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How to stay cool in a hot market

Larissa Fernand  |  28 Jan 2021Text size  Decrease  Increase  |  
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The irrational behaviour of some investors is the result of wrong answers to relevant questions.

Should I dial back on risk? Are there still crazy gains to be made in this market? I have already missed out on the rally, should I capitalise on what is left? Should I increase my equity exposure?

I admit that there is no right answer because it all depends on how long you want your money invested. If retirement is around the corner, it will make sense to get some gains out of this rally. The answer changes if retirement is over a decade away. If you have lost your job and have no emergency fund, you could sell some equity to help you tide over these times. But why would you if your cash flow is intact?

It is also fairly evident that the recency bias is at play, leading investors to believe that this run will last forever. Consequently, they have plunged headlong into equity and trading.

MORE ON THIS TOPIC: 3 steps to avoid financial fragility in 2021

Over the years, Steve Wendel, Morningstar’s head of behavioural science, has cautioned investors on being their worst enemy. Here I outline his key pointers to keep emotions in check.

Volatility is just data

Volatility is inevitable. It comes with the terrain. But it prods us to rely on “gut feeling” and provokes us to acting out on our cognitive biases. In market downturns, it leads to panic selling. In a booming stock market (especially when fixed return investments are delivering low returns), there is the tendency to go all into equity, or at least allocate a disproportionate part of your portfolio to it.

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Understand that volatility, downward or upward, is just data. If it evokes emotional responses, avoid looking at it daily. It serves no purpose other than warping your behaviour and getting you into trouble.

Our minds play tricks on us

There’s nothing we can do about market gyrations and its unpredictability. In less than a year we saw a gut-wrenching drop and a mind-boggling recovery. But it is the story we tell ourselves that matters.  

We think forward to what will happen, and our minds take that data and apply a story. And recency bias is at play—thinking that what just happened will continue happening. I personally know investors who had sleepless nights in March and are oblivious to the equity-heavy portfolio they are now sporting.

It always helps to round out the story. This just happened; this is what I believe is about to happen; what's the right thing to do?

If the market has fallen dramatically, it means you look for bargains. If it is rising rapidly, you revisit your asset allocation which probably has become imbalanced in a soaring bull market.

Viewing the same data and same market movement with a different narrative has a very different outcome.

Lock yourself in

The inspiration of the lock-in is Ulysses on the mast in The Odyssey. He knew that he would be tempted by the siren's call, so he had his crew members tie him to the mast so that he would be unable to jump overboard. This is very good metaphor for what happens in volatile times. We are tempted to tinker with our investments and flee in panic or plunge in dangerously.

Locking in comes with the terrain in some investments. For example, the 15-year Public Provident Fund, or the 5-year National Savings Certificate, or the 3-year Equity Linked Savings Scheme prevents you from taking the amount out. Alternatively, you may have bought a few stocks and decided to sell them only when you retire, so you ignore their price movements. Here you are tied to your investment goal and have removed the power to change.

This is impractical across the board. There are instances where the bonds are looser, which brings us to the next point. 

Increase social friction

Let’s say you tell your friends / spouse / investment colleagues that investing in emerging markets is a terrible idea, and why you believe so. A few weeks later when you see that your portfolio performance isn't doing so well and emerging markets are really ramping up, you will not rapidly change your mind because of your image. You would be thinking, "I just told these guys this, and they are going to think that I am inconsistent. They are going to think that I am a bad investor." That puts that little bit of friction to stop you from making a poor choice.

Set rules that will enable you to acknowledge your emotions but will put some time between your impulses and your behaviour.

  • I'm going to have a three-day waiting period before I make any change.
  • Only if the market drops by X percentage in a particular amount of time will I intervene.
  • I will make a trade only after consulting with my spouse.
  • Before I turn my intention into action, I am going to list down all that can go wrong. 

Look at the emotional power of your investment policy statement. Look at what you wrote for yourself—or if you haven't already written one, you should do that. Write out not just what your financial goals are but why you care. What matters to you and how that expresses who you are.

In times of extreme movements, look back and revisit what you fundamentally care about and what you value. Has it changed? Probably not. It's a counterpoint to the vivid, crazy stories that can go in our heads.

Fight vivid with vivid

Vivid images of market upheavals are only one of the things that we can pay attention to. Think about what this means for your goals. Probably not too much and especially in a 20- to 30-year horizon. What are the other things you have to do in your life? Play with your children, help your family, do your job, engage in philanthropy and so on. Balance that one vivid screaming thing over here with all the other things you have to do in your life. It can help put things back in perspective.

is the editor of the Morningstar India website.

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