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A funny thing happened when I wrote recently about my favourite investment maths and hacks , my mum chimed in with: “You owe that column to me.”
I was 18 when she frogmarched me to a (predictably for those days) male stockbroker.
Besides actual stock picks, what he spoke about was the ultimate investment success formula: regular investment plus dividend reinvestment.
Consistency, then simply keeping money in there is the secret to powerfully compounded returns.
But in uncertain sharemarket times, including those right now, your “heart” may want to override smart investment strategy − and make silly selling decisions.
Market pull-backs – when they flow straight through to your portfolio’s worth – are significantly psychologically uncomfortable. Retail investors often ease this discomfort by switching to some degree into cash.
Let’s use the pandemic panic to illustrate the problem. The ASX 200 fell 36 per cent between February 20 and March 23, 2020. But it was back to its pre-COVID levels just over 14 months later. Anyone who “cashed out” when markets were tanking – and I talked to a lot of investors who did – missed the bounce.
The recovery from the credit crack-up took a fair bit longer − in fact, nearly 12 years! But it was a prolonged and painful fall that lasted more than a year from a late-2007 peak to its early-2009 low − wiping more than 50 per cent off the market. A lot of investors locked in losses at big lows.
It’s virtually impossible to pick the bottom of the market and the inflection point where you want to be invested again.
The key is to avoid your “heart” hijacking your portfolio’s performance. Let me introduce you to five potential in-built psychological biases to watch out for − the ones that hold back and even hurt many investors.
Loss aversion: A loss hurts about twice as much as an equal gain feels good. So people want to act to stop it and stem that discomfort. Be aware.
Herd mentality: If everyone’s buying, it must be safe. Trust me, it isn’t. Indeed, this is the famous “bellboy barometer” from just before the 1929 stockmarket crash: if everyone is buying, it’s likely the very top of the market. (Hello crypto, at various stages.)
Recency bias: What just happened feels like it will keep happening – and that goes for up or down market trends. That’s simply not true.
The next two psychological biases could cause you to hold on to individual stocks – bad decisions – longer than you should:
Overconfidence: This creates the hindsight or “I-knew-it-all-along” trap. It’s so not helpful when it comes to investment.
Confirmation bias: Equally unhelpful, this might cause you to hunt for proof you’re right and skip the bit that says you’re not. Again, it can sabotage sensible investment decisions.
Then there are biasing hormones you may need to overcome.
Dopamine is really the thrill-of-the-chase hormone. It spikes when we expect a reward, for example a hot tip, soaring stock prices, checking the investment app. But bagging a bargain also triggers dopamine, so try to spin this propensity to see if you can snare some good value shares during volatile times.
Serotonin is more of a steadying brain chemical. This helps regulate mood and patience, and sustain effort. In investment, serotonin supports that patient, long-term strategy that my stockbroker was promoting all those years ago.
Cortisol or the “alarm hormone” is what you really need to look out for when the market dips. It’s the one that will make you panic sell, possibly at the bottom and thus miss the recovery. And it’s the one you typically need to override.
So, let’s look at the hormone and “heart” hacks that make smart investment decisions easier in tougher trading conditions. And how to automate them.
There are three concrete trading rules you can implement to override the above − just in case you need to.
Set stop losses: A conventional stop loss works by choosing a certain level below a share or unit’s purchase price, say 20 per cent − if it dips below the price, you sell and stem your losses.
However, if you want to be sure to also hang on to some of your gains should the investment instead rise, and still protect against falls, what’s called a trailing stop loss might be your pick.
This is a dynamic market price a certain amount below the highest price hit. Say 20 per cent. You can probably set up a trade order with your broker to automate both.
You might do it for only a portion of any investment, so you stay invested for any upside.
Extract principal: Gains are only paper gains until you crystallise them. That means they’re subject to fluctuations due to market sentiment. And negative movements might do nothing positive for your “market sentiment”. Indeed, it might make you far more comfortable if you progressively sell your original stake, such that you’re then only playing with “house money”. You could re-invest this elsewhere, then rinse and repeat.
From a practical point of view, you might sell 25 or 50 per cent of your holdings when the stock hits a pre-defined target such as a 25 per cent or 50 per cent gain. Again, you keep exposure and ride the market but only with profits.
You could get more defensive with this too and automate profit taking. A profit-taking strategy locks in paper gains and prevents market pullbacks from erasing your returns. Basically, you could sell further bits of a winning position in incremental stages.
But this approach comprehensively erodes your compounding advantage. So be sure – as that broker told me when I was 18 – to get that edge via regular scheduled investment deposits, with dividends or distributions reinvested.
It’s really that simple. “Fractional” investment apps such as Sharesies and Raiz will let you set a direct debit on pay day of whatever you can afford − it doesn’t have to be large.
And that is the best way to fight market volatility as well – you get more shares or units when prices are low, which means more shares or units to grow. Remember, it’s consistency and simply keeping the money invested that triggers compounded returns.
And automating it is the way to turn market swings − even wild ones − to your advantage.
Follow the above to help you tame your investment brain and protect your portfolio − no matter what.
Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.
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