Every day the market provides a stage for conflict and disagreement. This is because, for every person who wants to buy a stock, someone on the other side of a computer screen must passionately and vehemently disagree and therefore be willing to sell.
Many investors are lured to the share market for many different reasons, be it either the capacity to achieve significant growth in the value of their capital over the long run and/or to generate a regular stream of income to fund their lifestyle. But no single investor is the same, nor is our investing psychology. Share investors accept that the share market is inherently volatile and always will be.
However, based on our past experiences, our age and/or our capital to invest, as investors, our individual tolerance to risk does vary. For example, some investors will see ‘volatility as an opportunity’, while others see it is as a future disaster waiting to happen. So, based on whether you are half glass empty or half glass full investor, how should you approach investing in the share market?
Are you an opportunist?
An investor that is an opportunist embraces volatility as a friend, maintaining confidence in their ability to deliver outperformance over the long run. Opportunists seem to have mastered the psychology of investing and are conditioned to markets behaving normally. Techniques that an opportunist will employ within their portfolio include:
- Strong focus on the ‘potential’ growth of a business
- Will often pay a premium price today for the profits of tomorrow
- Holds a spread of quality companies, but is happy to be concentrated in sectors where the good businesses are
- Is prepared to seize opportunities to top-up when prices pull back to bring their average purchase price down
- Will maintain a sufficient cash pool to seize these opportunities if and when they do occur
Or are you nervous?
A nervous investor will generally have less conviction in the quality of stocks to help them ride through volatile times. They are sensitive to large drawdowns in capital, often because of their past experiences or their age, particularly if they may not possess the long-term horizon to recoup their capital. Techniques the nervous investor will employ within their portfolio include:
- Holding a larger number of stocks as this insulates the portfolio from the odd stock that might disappoint
- Will look to take profits periodically, as nothing goes up forever and a bird in the hand…
- Looks to hold only positive trending stocks finding comfort in the market’s positive view of the stock
- Avoid down trending stocks until the trend reverses to dodge any future troubles
- Will use methods such as technical analysis or tight stop losses to ensure no big drawdown occurs
Risks both types of investors must avoid
Though different types of investors can benefit from employing the styles mentioned, with some even blending elements from both within their plan, there are risks to blindly being either an opportunist or a nervous investor.
For an opportunist, the biggest risk is ‘overconfidence’, a behavioural bias where an investor tends to overestimate their knowledge, underestimate risks and exaggerates their ability to control or predict events, particularly if they have had a few wins in a row. This can lead to high-risk-taking, irrational trade decisions, and portfolio neglect when they make the wrong call.
For the nervous investor, their biggest risk is ‘loss aversion’, a behavioural bias where the pain of losing is psychologically more powerful than the satisfaction of gaining. This can lead to them acting irrationally, selling and then failing to buy back despite the attractiveness of an investment opportunity. Over the long-run markets rise, so not being invested means they will underperform.
The solution for all investors is to have an investment plan
The above risks can be managed with a well-defined investment strategy that you adhere to with discipline and governs all your decision making. We educate our Lincoln Stock Doctor members that no matter what their tolerance to risk, if time is spent constructing a detailed plan based on their investment objectives, then any future decision they need to make will not be subject to emotional bias. Rather they just simply block out the noise, follow the bouncing ball and let the strategy tell them what to do next.
As with anything related to personal development, understanding yourself is the first important step to achieving success. When investing in the share market, following rules, routine and structure set you free. This means that if both parties to a trade have a strategic basis for making decisions, they can sleep well at night knowing it was in their best self-interest.
ELIO D’AMATO (@Elio_DAmato)
Elio D’Amato is the Executive Director at Lincoln indicators, a leading boutique fund manager and creator of Stock Doctor share market research platform. www.lincolnindicators.com.au