Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Keep a lid on your emotions
There is an old saying that financial markets are driven by two conflicting emotions – fear and greed. Letting them control your investment decisions can have a hugely detrimental impact on your portfolio.
In the UK, fear is the emotion that holds the majority of investors back. Recent research by fund manager Henderson found UK households hold half of all their financial assets in cash, despite it failing to meet their stated investment goals.
Peter Chadborn, director at financial advice firm Plan Money, says there is a general misconception that money in the bank is not at risk. This is largely because people don’t understand the importance of inflation and the effect it has on capital in real terms.
‘The Consumer Price Index is currently 0.6% and most money on deposit in bank and building society accounts is getting nowhere near that in terms of interest. So it may feel like deposit-based savings are safe but in real terms they are losing value. Then we need to introduce the concept of compounding, or negative compounding in this example, and at this stage it should become clear that money in the bank is no place for long-term investing,’ says Chadborn.
For people who do invest in the market, fear often causes them to panic in a downturn and sell stocks that have dropped in value, thereby crystallising their losses. If there is a market rally, greed takes over and causes investors to buy at the top.
Russ Mould, investment director at AJ Bell Youinvest, suggests investors draw up a checklist with six to 10 points to help decide whether a potential new pick or a current holding meets their investment criteria.
‘This imposes a discipline and makes you stop and think before you do something rash and potentially costly,’ he explains.
Deciding your attitude to risk is one of the most important things to get right when you’re investing. There are a few key factors to consider to help you get more comfortable with risk. The first is your investment timeframe.
‘Over the very long term equities, particularly once dividends are taken into account, have delivered very good investment returns. So, if someone is 35 and they are investing via their pension they have at least 20 years before they can even think about withdrawing their money and even longer than that in most realistic circumstances. They will therefore have time to sit tight and ride out any short-term market volatility,’ says Mould.
Another factor to consider is asset allocation. If you’re worried about the risks associated with investing in equities, you can take that into account when deciding how to split your money.
‘There is an old rule of thumb that says you take your age away from 100 and that gives you the proportion of your portfolio that should be invested in equities. So a 35 year-old would have 65% of their portfolio in equities, whereas a 65 year-old would have 35% in equities,’ says Mould.
You could try one of the online risk profiling questionnaires to help determine your risk attitude. Moo.la, a digital investment service, presents its questionnaire as a game which aims to tap into people’s subconscious and build a fuller picture of how they will behave through the lifecycle of an investment.
Gemma Godfrey, founder and chief executive of Moo.la, says investors shouldn’t ignore their emotions because peace of mind is important.
‘If seeing a whipsawing value will cause a great deal of concern, then it may not be the right thing to buy. Another interesting reason not to ignore emotions is that often markets can move due to broad investor “sentiment”, therefore if a person is aware of how they feel about an investment, beyond the facts, this can sometimes give an insight into how the wider investor community will react,’ she adds.
Balancing your equity exposure across different geographies and sectors is a good starting point. You could also consider investing in different assets such as bonds, property and commodities.
James Horniman, portfolio adviser at James Hambro & Partners, says investors can learn to come to terms with risk.
‘There is an investment mantra that you should take more risk when you are young and less when you get old. I think that’s dangerous. Younger investors may be better served taking more moderate risk in the first few years until they’ve come to terms with the way markets dip and recover, otherwise they may get hurt and panic and never trust the markets again – which is a bit like cutting your leg off because of an ache,’ he says.
It is probably impossible to take emotions entirely out of the equation when investing, we’re not robots after all, but by understanding the risks and your responses to them you stand a better a chance of achieving your financial goals. (EP)