Investing Part 12 -- Keep emotions in check
“It will fluctuate.” –J.P. Morgan, when asked what the market was going to do.
In the current Internet-Information Age, you’d think that all investors should do better. After all, you can find out almost everything there is to know about any stock or mutual fund. Why, then, have so many lost miserably during market corrections? Simple: Information is useless when we let emotions interpret it for us.
Amateur investors base what should be long-term decisions on short-term information. They look at last year’s mutual fund return or a recent earnings estimate on a stock and assume the trend will continue forever. At the end of 1999, investors could look back at the previous five years and see that growth stocks had grown much quicker than value stocks. You can guess what happened—value stocks completely dominated growth stocks in 2000 and for many years hence.
Taking emotions out of investing should be a major difference between amateur and professional investors. Yet sadly, even “professionals” react emotionally to the ups and downs of the market.
Don’t invest in an area just because it is doing well. First, determine if it makes sense as an investment, then decide if it fits your needs. Finally, check that it works in concert with the rest of your portfolio.
For instance, beginning in 1996, if you had purchased the top mutual fund from the previous year, over the next five years your average portfolio return would have been negative 2%. That’s not to say that every winner turns into a loser—but it does show that looking backward when picking your funds, or any other investment, can be fraught with error.
Just as you should not run toward the hot asset classes, you shouldn’t shy away from the ones that have recently run cold. When a particular investment type makes sense for your portfolio, don’t automatically write it off as “bad” just because it had a rough year. If anything, it might be a good buying opportunity.
No trend lasts forever. Cycles are a fact.
Here’s an illustration I heard from the American Century Investment Services that will help pull this together: Imagine that you had to drive from New York to Los Angeles. You are in downtown Manhattan hopelessly stuck in traffic. Bicycle messengers have been whizzing past you for the last hour. Inspired, you sell your car at a loss and buy a bicycle. Now you are whizzing by all those idiots still in their cars.
Sound absurd? Investors do it everyday when they make short-term decisions for long-term journeys. Initially, they look brilliant. But eventually, they are left in a cloud of dust.
Don’t strap on your bike helmet out of irrational excitement. Stay in your car, pop in a CD, and relax.