The Star Wars epic may be one of the greatest movie series ever created, but it can also offer us some lessons on how to manage our investment behaviour when the market is volatile.
Yoda said it best when he told a young Anakin, “patience you must have.”
For some investors, the recent market volatility has resulted in anxiety and concern. In this article, we’ve outlined some of the common pitfalls that lead to harmful investment decisions and explain that the most important variable in your investing success – and the only thing you can control – is your behaviour.
Don’t be a Darth Vader driven by emotions.
Darth Vader is the ultimate example of someone who started off on the right track but, motivated by emotion, ended up on the dark side. Many of us have common emotional behaviours which can threaten our financial security. Fear, greed, indecision and regret are the emotions most frequently linked to harmful investment decisions.
In the case of planning for your future, there is at least one tendency that we’ve all succumbed to on occasion. It’s the feeling of instant gratification that causes people to overemphasise immediate rewards at the expense of long-term needs. Below is a list of tendencies that as humans we must overcome to become more stable, rational investors;
1. Overconfidence leads to losses of profits (and limbs).
Overconfidence in your prowess as a market prophet can also be detrimental to making market profits – or survival in general if you’re Anakin Skywalker. When markets advance enough to get the casual investor’s attention, many often start to think their success is the result of skill, rather than cyclical luck. Obi-Wan-like patience and careful planning are paramount for long-term investment success. I think we all know how the scenario below turns out for the young Darth Vadar, if only he’d listened to Obi-Wan’s advice!
2. “Your eyes can deceive you, don’t trust them” – Obi Wan Kenobi.
In the world of finance “Representativeness” describes the tendency for investors to underweight long-term averages and put too much weight on recent or current events. This behaviour causes misguided decisions at both good times and bad, as fear and greed override long-term prudence. It’s reactive, not proactive, and the response often causes people to buy high for greed’s sake and sell low out of fear.
3. “Train yourself to let go of everything you fear to lose” – Yoda.
The fear of loss is the path to irrational investor behaviour (and the Darkside). Investors often also fear loss more than they seek gain. Loss aversion makes it difficult to put your money to work outside of a “safe” investment (eg term deposits), even if that perceived safety means inflation may destroy your purchasing power over time. Loss aversion causes people to plan for worst-case scenarios to minimise losses rather than trying to maximise wealth.
How to become a super Jedi and avoid dark side behaviour
1. Determine your Risk Tolerance.
Yoda: “Difficult to see. Always in motion is the future.” As an investor it is important for you to determine how motion is comfortable with. Equity markets will always experience periods of volatility and uncertainty. Are you an aggressive investor who is happy to ride the roller coaster of ups and downs? Or are you more conservative? Can you tolerate wide swings in the market, or are you willing to accept potentially lower returns for lower volatility? Determining your risk tolerance is one of the first steps you should take in setting out your investment plan.
2. Stay diversified.
After seven movies and three versions of the Death Star destroyed it’s obvious that senior managers of the Galactic Empire need a good financial planner to educate them on the benefits of diversification. Diversification of assets limits downside losses in difficult markets and to eliminates unsystematic risks that face a single company or asset. If a market correction happens (such as what we’ve seen recently) and you’re properly diversified, you’ll be less likely to lose a substantial amount of money, have a portfolio that is in a better position to rebound when markets improve and are less likely to be forced sell at the bottom.
3. Think long-term.
When things started looking grim for the Jedi, Yoda and Obi-Wan made some solid long-term decisions after the birth of Leia and Luke that ultimately led to restoring balance to the galaxy decades later. It’s good to remember that markets will always change and that in the history of share markets, very few individual events have had a meaningful impact on long-term returns.
Here on planet earth history has proved that not the assassination of President Kennedy, not the fall of the Berlin Wall, not 9/11 and not the start of the wars in Iraq and Afghanistan have had a lasting impact on the performance of financial markets. In each of these cases, the US share market (S&P 500) stood higher two years after the event occurred. Broadly speaking, in time, markets tend to recover from events that may seem overwhelming in the near-term.
May the force be with you!