Make a plan, and stick to it

BAD NEWS: PREPARATION, ANALYSIS AND HONESTY KEY

If a market falls significantly, expected future returns must rise.

If you could get 30% off your shopping, how would you feel? If the market fell 30%, how would you respond? Would your reaction to these two events be the same? If not, why?

If the JSE drops 30%, you can buy the same shares for 30% less than before. If these are the same companies with the same earnings potential and cash flows, aren’t you getting a bargain?

Most investors will probably react with fear and panic. Many will sell out of their holdings, locking in the losses.

Yet history shows the periods after big market downturns can be the most rewarding.

Behavioural biases

Logically, if you can buy shares heavily discounted, your potential future returns must be much higher. For most investors, however, the focus is on what just happened.

“We all suffer from behavioural biases,” says Morningstar Investment Management EMEA’s Dan Kemp. “We are predictably wrong in certain circumstances and those tend to be when we have to make really important decisions.”

Behavioural economics is the study of why we make the financial decisions we do, pioneered by psychologists Daniel Kahneman and Amos Tversky. Kahneman identified that in all decision-making, we’re in conflict with ourselves.

Two systems

“We really have two selves,” Kemp explains. “Two patterns of thought.”

Kahneman said, when operating in system one, we’re entirely responsive, selfish and instinctual. In system two we’re logical, thoughtful and slow-moving.

Both have their place.

“If you are crossing the street and you see a truck coming towards you, you want to be in self-preservation, automatic mode. But there are other times, such as when making investment decisions, that you want to be in system two,” says Kemp.

However, moving from system one to system two isn’t always easy, particularly when outside stimuli induce a reaction.

In a market crash, for example, headlines carry emotive imagery like “blood on the floor”, and you can expect pictures of traders with their heads in their hands.

That prompts you to think in terms of self-preservation and to get away, fast.

However, this is the time to think logically and unemotionally. We need ways to move out of system one and into system two, where possible.

Have a plan

Blocking out the noise is almost impossible. You won’t be able to escape the news, social media posts or office talk, so you need a plan.

Kemp recommends having a set of investment principles to guide every decision you make. If they’re sound and reasonable, they’ll stand even when markets turn against you.

Also, think about how you look at the data you have. If a market falls significantly, expected future returns must go up. Which are you paying more attention to?

When making any investment decision, go through your checklist to see if it meets your criteria – eg do they reflect your principles, are they long-term focused and valuation driven?