How to keep emotion out of your investment decisions

Post on: 31 Май, 2015 No Comment

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Its easy to trot out numbers to show why its impossible to move in and out of shares and make a gain, but all these numbers really show is that people who sell to avoid a loss have an equally important second decision: when to re-enter the market.

Timing makes all the difference

People invested in Australian shares for the 20 years to December 2010 made an average annual return of 6.9 per cent before tax. A tidy gain.

But had they missed the 10 worst days in that two decades, their gains would have jumped to 10.2 per cent, and had they missed the worst 40 days, the result would be higher again at 16 per cent. Of course, missing the worst days would have required luck and skill. It would also have required luck or skill to ensure you were in the market for the best days.

On the flipside, people who missed the 10 best days of the past 20 years would have gained just 4.4 per cent and thats before tax and if theyd missed the 40 best days, they would actually have lost money.

Volatility makes it even harder

Getting both decisions right multiple times in an economic cycle is difficult especially when markets are as volatile as they have been. says John Dani from iPac Securities, a financial planning company.

Some people might be smug after switching most of their investments to cash either before the GFC or before the markets latest slide but now they have to think about when to re-enter the market.

Dani acknowledges the mathematical reality that people can sell when the market is high, buy when it is low and make a lot of money but human beings find it difficult emotionally to consistently make the right trading decisions.

Absolutely petrified

When the sky is falling down and we are bombarded by negativity, we are emotionally ill-equipped to time the market. It takes extra courage to overcome that negativity, and most of us dont have it, Dani says.

The reality is that most people are more likely to be paralysed by fear, and either do nothing or sell when the markets are falling and buy when everything looks good, which is generally when prices are higher. The only way to remove emotion from a decision is to rely on a strategy that generates signals indicating when to buy and sell, Market Timing chairman Percy Allan says.

Allan argues it is possible to manage risk by timing the market and following trends. His company identifies trends by analysing share price movements and economic developments in order to advise investors when to be in the market and when to get out. It has three strategies active, conservative and ultra-conservative where signals are generated to buy or sell exchange traded funds (ETFs) that invest in Australian shares.

ETFs are listed managed funds that trade on the Australian Securities Exchange. making them more liquid and cheaper than most unlisted funds. They generally replicate the performance of the top Australian companies.

A good nights sleep

We are not trying to predict the market. Only fools do that. What wedo is identify when the market ishealthy and when it is sick. That way people can sleep well, Allan says.

Even if the signals are correct only half the time, the 50 per cent that are right are more profitable than the 50per cent that are wrong, he says.

Allan says people need signals to tell them when to exit the market.

Using our strategies doesnt mean they get out at the top and in at the bottom, but it smoothes things out considerably. If you can avoid the crashes you are in a good position to get back in at a lower price and continue growing , he says.

Someone following Market Timings conservative strategy, which meant following between one and five signal changes each year, would have beaten the overall market in three of the past five years. But because the gains in the good years have been so much greater than the losses in the worst years, overall the conservative strategy would have returned 7.4 per cent compared with a 1.5 per cent loss had they bought and held the same ETF.

The active strategy, which requires between one and nine signal changes a year, beat the market in two out of the past five years. But someone following the signals would have made 6.4 per cent compared with the 1.5 per cent loss had they held the same Australian equity ETF.

We dont claim it as a quick money-making scheme. Market timing might not even beat buy-and- hold by much, but it helps smooth out the returns, Allan says.