When people think about the biggest risk to their investments it’s usually along the lines of market crashes, inflation or lack of time. While these things will all certainly put a dent in your returns, there’s something that can be even more detrimental – and it’s something there’s no getting away from.
Many believe investing is all about numbers, charts, economic figures and forecasts. There’s far more to it than that though. How you think, feel and act can impact your investment returns just as much, if not more. Unfortunately those thoughts, feelings and actions can work against us. It’s why the average investor’s returns are actually worse than the returns of what they invest in.
How can that be you might be wondering? Read on to find out, and discover what you can do to stop yourself holding back your investments returns.
Expecting the past to repeat
All too many investors base their decisions on nothing more than how something has performed in the recent past, such as over the last 12 months, expecting similar returns in the future. The result of this ‘performance chasing’, however, is you only invest in things that have performed well recently and avoid anything that’s struggled lately. Any investor worth their salt will tell you, however, past performance really isn’t a good guide to future returns. Top performers in one year can become the worst performers the next, and vice versa.
Different investments perform well or poorly in different market conditions. So making investment decisions on what’s performed well lately only really helps you if recent conditions persist. Markets though, like economies, are cyclical. Conditions rarely stay the same for the long-term. That’s why your portfolio should contain a blend of investments that work well in different environments, not just recent ones.
Fear of missing out
Following the crowd, or fear of missing out (otherwise known as ‘FOMO’) usually involves seeing others making money from something and then investing yourself to get a slice of the action. The trouble with this is many invest without understanding what they’re getting into, and with little-to-no regard whether it’s right for their circumstances or risk appetite. Not only that, by the time a ‘sure-fire-winner’ has reached mainstream attention the strongest returns have often been and gone. Worst still, it could be just before returns head south.
Although the pull of the crowd and FOMO can be very strong, particularly where others have made large gains, make sure you properly understand what you’re investing in first. That includes finding out how volatile the investment can be to see if you can stomach both the ups and downs. In general though, if something’s made the news you’ve already missed the biggest gains. To avoid falling prey to FOMO, make sure you only invest in things that fit with your long-term investment plan and risk profile.
Mistaking luck for skill
Sometimes in investing, you can get lucky. Imagine someone believes an investment will do well. Instead of just doing well though, it soars. The investor feels like a genius – he ‘knew it all along’. Except really he didn’t expect it to do as well as it did. He got lucky and the returns were more down to good fortune than skill. Having a slice of good luck to be in the right place at the right time can lead to funds being rated more highly than they really deserve. From an individual investor perspective, it can lead to over-confidence in their own abilities.
Eventually though all luck runs out. Skill on the other hand is repeatable. Without the right tools and data though, it can be difficult for everyday investors to distinguish between the two. That’s why it’s helpful to have a professional investor drill down on the performance of funds to separate the lucky from the consistently skilful.
Emotions can push you towards investments that make you feel good and away from those that make you uncomfortable. How you feel about an investment though has no bearing on how it’ll perform. Human nature prefers things as they are (a.k.a. the status quo). That means investors may avoid making changes to their portfolio even if it could benefit them. It’s also easy to ‘fall in love’ with your best performers, and view them differently to your other holdings – the rose-tinted-glasses effect. Investors also commonly select areas and companies that are familiar to them, perhaps because they work in that industry.
This can result in portfolios that are too concentrated in particular areas, or decisions based on feelings rather than sound reasoning. Emotions are hard to overcome, and most investors aren’t even aware they’re having an impact. So unless you’re good at self-reflection, it’s wise to get a professional second opinion. That person can spot if you’re making emotional decisions, and nip them in the bud before they can have a potentially harmful impact on your returns.