The denial factor – An investor’s worst enemy
The current economic environment is demonstrating many of the features commonly seen just before a difficult period in the equity markets. Furthermore, many people are claiming: It’s different this time because:
The denial factor, or reflex on the part of investors to rationalize the negative aspects of the market, or conversely, to hold onto a diminishing number of positive attributes, can also be added to this list.
Investors would usually like equities to go higher, which may cloud their judgment. However, a wise investor is a rational investor, one who considers the negative side as well, and has a portfolio of investments that are not caught up in the frenzy of the market – a rational portfolio.
Current market conditions are quite good; global economic and domestic growth is still strong. Core inflation is low, both in Canada and around the world.Yet there is a degree of fear due to many potential problem areas. Some are real while others are likely overstated. We also have geopolitical issues. Concern exists about the Avian flu, which could be devastating if it spreads between humans. There is also the possibility that the central banks may overshoot on interest-rate hikes and the housing bubble could deflate. These events can cause fear among investors and result in tension in the markets.
It is said that markets are motivated by two emotions: fear and greed. We agree that many investors are affected by these emotions. However, other strong feelings such as hope, pride, regret, and embarrassment also affect our decisions. No matter what the emotion, acting on any of them is rarely a wise move, as they can obstruct the formulation of good investment decisions.
Some Points to Consider
Each investor should examine these points when making investment decisions:
Unacceptable risks should never be taken. For example, it would not be seen as sensible to invest all of a high school senior’s university tuition savings in the stock market because if the market went down, the student might not be able to pay the tuition bill.
As the axiom goes, some investors care about eating well and others are concerned about sleeping well. Smart investors should stay well within their tolerance for interim fluctuations in portfolio value. The emphasis on informed tolerance is deliberate. Avoidance of market risk has a real opportunity cost, and the investor should be fully informed of the opportunity cost of each level of market risk not taken.
Investing does not always make sense. Sometimes it seems almost perversely counterintuitive. Lack of knowledge tends to make investors overly cautious during bear markets and too confident in bull markets, sometimes at considerable cost. Wise investors should be careful not to assume that they are suitably sophisticated in the ways of the market.
The investor who is well informed about the investment environment knows what to expect. This investor will be able to take those disruptive experiences in stride that may cause less informed investors to overreact to either unusually favourable or unusually adverse markets.
Investors can do more for their portfolio’s long-term rates of return by developing and sustaining prudent long-range policies. These will commit the portfolio to a more appropriate structure of investments than can be done by the most skilful manipulation of the individual holdings within the portfolio. It is critical to diversify your portfolio, but keep in mind that at times certain portions of your portfolio may perform below par. You have to understand and accept this up front.
Once you have considered these points in light of the current economic environment, you should be in a better position to structure your portfolio appropriately.
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