5 mistakes investors make in volatile markets
Keytrade Bank
keytradebank.be
September 19, 2024
3 minutes to read
Bright green one day, dark red the next. If you take a look at the stock markets' trajectory in recent months, there is no escaping it: it has been quite a bumpy ride so far. These sudden mood swings are enough to make even the most experienced investors nervous…
1. Panic selling
It can be nerve-wracking to see your investment portfolio plummet, especially if you’ve been consistently building it up for years. The urge to stop the bleeding can be overwhelming – save what you can and then wait for the dust to settle. Ironically, this could be the worst move you can make as an investor. We don't have to go very far back in time to see this. If you had sold in a panic during the coronavirus pandemic, you would have missed some excellent years. The S&P 500 rose by 31.49% (total return) in 2019, by 18.40% in 2020, and by 28.71% in 2021*. Not bad at a time when the whole world almost came to a standstill.
*Source: slickcharts.com/sp500/returns If your broadly diversified portfolio is being hit, it's better to just sit tight. In 2007 – the year before the financial crisis – Warren Buffett placed a bet with Ted Seides, a hedge fund manager. The wager? Who would achieve the highest return in the next ten years. The prize for the winner? One million dollars. One remarkable fact is that Buffet and Seides' fight was unequal. Ted Seides was given carte blanche. He was allowed to buy and sell all kinds of financial instruments. And he could buy and sell as often as he wanted. While the hedge fund manager developed all sorts of complicated strategies, Warren Buffett only bought a single product, an S&P 500 index fund, which he held on to for 10 years. The result was clear and the fund manager threw in the towel prematurely. By the end of 2016, the S&P500 had posted an annual average return of 7.1%, while Ted Seides’ portfolio of hedge funds had been stuck at an annual average return of 2.2%. Even if the market is being shaken to its core in the short term, stay focused on the long term. If you don't need your money right away, and you have a well-diversified portfolio, sit tight. Declines are always temporary. We have seen it time and time again: there's always light at the end of the tunnel, and there tends to be far more light than darkness on the stock market.
2. Staying on the sidelines
One of the biggest mistakes investors can make is to sell their investments and then stop investing their money. This mistake actually exacerbates the damage of a panic sale. Historically, a sharp decline in the stock markets tend to recover just as quickly. The best days and worst days are often not that far apart. And if you miss those good days, you will fall much further behind. If you invested USD 10,000 in the S&P 500 back in 1994, that would give you a total return of USD 181,736 30 years later. However, if you missed the 10 best days of those 30 years, your final return would be 54% less (USD 83,272). And if you missed the 20 best days of those 30 years, your final return would be 73% less (48 874USD ). If you did sell in a panic, your best option is to reduce your cash position again and return to the market, particularly if you are holding more cash than you need. One way that you can avoid panic selling (and then being sidelined) is to make periodic investments. This means investing a set amount on a regular basis, for example monthly, regardless of the market conditions. This offers two advantages: you avoid the timing pitfall, and you take the emotion out of your investment decisions. This can also put investors' minds at ease as they gingerly re-enter the market after a decline. After all, this means they do not have to invest all their money at once, which can be less stressful in volatile times. Once the market starts to rise again, you will also be pleased that you put in your money a little bit at a time. This avoids the risk of staying on the sidelines for too long and missing out on important opportunities once the market recovers. The trick is to balance patience and action, and a periodic investment strategy can play a key role in this.
3. Overconfident behaviour
Overconfidence is an often underestimated pitfall for investors, especially in volatile markets and especially for investors in individual shares with a portfolio that is not very diversified. It may seem tempting to think that you can strike a bargain at the right time or that you know exactly when a share has bottomed out. This phenomenon known as anchoring means that investors fixate on a much higher share value from the past without taking into account the current market conditions or the potential for further decline. Even experienced investors get overconfident. This often leads to impulsive decisions aimed at short-term profit that end up undermining the portfolio's stability. Short-term trading may seem profitable on paper, but in practice it is particularly difficult to keep hitting a bull's eye. The reality is that the markets are volatile, and even the most skilled investors can get their timing wrong. So what can you improve? You can build a solid foundation with diversified investments. Rather than go after individual shares, you should consider more stable options such as investment funds or ETFs tracking a broad market index. Are you investing in an AI share and you still want to capitalise on this theme? Consider selling the share and investing your funds in an ETF that tracks dozens of AI shares. This allows you to even out some volatility. A well-diversified portfolio is essential to manage risks, especially in uncertain times. Investors who invest too heavily in a single share, sector or asset class run the risk of being disproportionately hit when it comes under pressure. Striking a good balance can help to absorb the impact of volatile markets and increase your portfolio's overall stability.
4. Trying to make up for losses quickly
Another common mistake investors make in volatile markets is they try to make up for their losses by making riskier or rushed decisions. Instead of calmly rebuilding their portfolio in a structured way, they take risky positions in the hope of a rapid recovery. Say you took a significant loss on a particular investment: the natural response might be to invest in a share that has fallen sharply very quickly, with the expectation that it will also recover quickly. This is a dangerous wager, though. Not only can the markets fall further, but your impulsive choice to 'reinvest' in something that looks like a bargain may lead to even greater losses. Another example is the rapid shift of investments towards so-called 'high-flyers’, shares that performed better during a crisis such as value stocks or shares in defensive sectors (such as healthcare or food). This strategy may seem logical, but these shares may already be overvalued. Moreover, what went up in the past does not always keep going up in the future. What can you do to avoid this pitfall? The answer is discipline and realism. Instead of trying to make up for your losses in a hurry, it is important to stay true to your long-term strategy. Temporary dips are part of investing. The best way to deal with them is to truly diversify your portfolio in advance, for example with ETFs. Losses sometimes takes longer to recover than you had hoped, but your patience will often be rewarded.
5. Not rebalancing your portfolio
In the event of a sharp correction, different asset classes such as shares, bonds, commodities and gold often don't move in the same direction. When shares are hit, we often see bonds or gold doing better. This means your portfolio's asset allocation may become unbalanced. Whereas you may initially have had a nice mix of 70% of your portfolio allocated to shares and 30% to bonds, for example, a sharp drop in the stock market could mean that 50% of your portfolio now consists of shares and 50% bonds. This can change your risk profile significantly without you having actively chosen to do so. Not rebalancing your portfolio is therefore a common mistake. Rebalancing means adjusting your investments to get back to your original asset class allocation that corresponds to your risk profile and objectives. This may mean, for example, buying shares after a sharp fall and selling bonds to rebalance the asset allocation. By rebalancing your portfolio, you can take advantage of buying opportunities when the prices of certain asset classes have fallen and you can prevent your portfolio from relying too much on asset classes that have risen in value. In the long term, this will help you to optimise your return and keep the risk under control.
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