Two common errors investors make…and how to overcome them
Understanding compounding and portfolio rebalancing could have helped investors overcome emotion-driven decisions during a turbulent six months for stock markets. Duncan Lamont shares why.
The past six months have highlighted two common errors that investors frequently make – misunderstanding the way investments compound over time and letting emotions cloud our judgement. With the right knowledge, both can be remedied relatively easily.
The impact of compounding
The US stock market fell by 13.7% in the fourth quarter of 2018 but has since rallied by 13.9% this year so far (as of 12 April 2019). 13.9 is more than 13.7 so that means investors are up overall, right? Wrong. Investors are actually down by 1.7% over this period.
A 13.9% return on $100 would indeed lead to a gain of $13.90, if the investment was made at the start of 2019. But, in this situation, a $100 investment made at start of October 2018 has fallen by 13.7% by the year end, to $86.30. As a result, you have
less capital to earn that 13.9% return on. Instead you only make back $12.00 (13.9% x 86.30). This takes your final amount to $98.30.
While this may seem a bit abstract, understanding the difference between arithmetic returns (i.e. adding them together) and geometric returns (i.e. compounding them together over multiple periods) is key in preparing yourself to make informed decisions.
Keeping your investments balanced
The end of 2018 was a difficult time to be investing in the stock market.
Stocks fell sharply, sentiment was rock bottom and the immediate emotional response would have been to sell.
However, during this time earnings- based measures of valuations had fallen to their cheapest levels for several years and markets rallied sharply from that low.
With hindsight, it would have been a great time to invest. But, we are hard-wired as emotional beings so overcoming the urge to sell is not easy. One way to take emotion out of the equation entirely is to follow a rebalancing policy.
Rebalancing starts with deciding what percentage of your investments you want in the stock market, bonds, cash, etc. If one asset class outperforms the others, its weight in the portfolio will rise. A rebalanced portfolio would then sell some of the specific winner, to bring its weight back to where it was initially intended it to be and reinvesting the gains in assets that have under-performed.
Remember to speak to your financial adviser before deciding if this is right for you. This is essentially “buy low- sell high” in practice.
Source: Schroders
