Looking to invest? Mind the volatility — and your emotions

The Reserve Bank is updating an online booklet I wrote for them several years ago, called Upside, Downside — a Guide to Risk for Savers and Investors. Over the past five weeks, I’ve been including excerpts in this column.

The updated booklet is being launched on the Reserve Bank website, rbnz.govt.nz, through this month.

Risky behaviour: Taking on more volatility than you can cope with

People often make their first investment in a particular type of asset after it has performed unusually well. Examples of this are international shares in the late 1990s and property in recent years.

The trouble is that the types of investments that sometimes grow fast are also the ones that go through periods of no growth or even large losses.

We’re all aware that share prices can drop fast. We watched New Zealand prices plunge following the 1987 crash, and international prices plunge in 2001-03. And pretty much all markets slumped in the global financial crisis and the start of the Covid19 outbreak.

What about property? While prices are less likely to fall fast, if you have borrowed to invest in property, you may find that a small fall in market prices translates into a much bigger percentage drop in the value of the money you put in. In some cases, your deposit will disappear or worse — as some people have discovered. Before you invest, try this test:

● In shares or a share fund, imagine discovering a year after you first invested that the value of your investment has halved.

● In rental property, imagine an annual review in which you find several of the following: property values have gone nowhere or have fallen; rents have fallen; insurance, rates, interest or maintenance costs have risen fast; or your ability to cover expenses, including mortgage payments, is in doubt.

Or imagine that your tenants don’t pay or do damage to the property, or you have long periods with no tenants.

What would you do? If you would get nervous and bail out, you shouldn’t make the investment. You could end up buying high and selling low, and that’s no path to wealth. Look for something less volatile.

But if you feel confident you could hang in there — in the knowledge that long-term investments usually regain their losses as long as you are in a welldiversified share investment or a sound property in a good area — the investment is right for you.

KiwiSaver

Before choosing a higher-risk fund, think about how you will handle the inevitable downturns.

Risky behaviour: Letting your emotions rule your investment decisions

People often make unwise investment decisions because of their emotional reactions. Understanding common reactions can help you guard against bad decisions. Reactions include:

● Responding to the way in which things are presented

People tend not to like an investment that loses money one year in 10 as much as one that gains money nine years in 10. Think about it!

Employees in a super scheme, offered a choice of five fixed-interest funds and one diversified share fund, put 43 per cent of their savings in the share fund. Others in the same workplace were offered a choice of one fixed interest fund and five share funds. They put 68 per cent of their savings in share funds. And yet you would expect the two groups to have had the same desire to be invested in shares.

Don’t let the range of options influence you.

If you were to look at a graph of average returns on international shares over one-year, five-year and 10-year periods, the one-year returns will sometimes be extremely high or low. When you average the returns over five years, though, the extremes are watered down. And over 10-year periods, the average has usually been less than 20 per cent, but losses are also minor.

Given that shares are a long-term investment, concentrating on the short-term is worrying and misleading.

● Sticking with the status quo List your investments and their approximate value. Then ask yourself: “If I were starting out now, would I spend that money on those investments?” In many cases, the answer will be no. So why don’t you sell and buy what you would prefer?

That’s not to say that you should flick in and out of investments because of what the markets have done lately. But it is to say that you should review your investments every now and then to see if they are still well spread across different asset types and still suit your tolerance for risk and how close you are to spending the money.

● Responding to terminology A super scheme changed the title of one of its funds from “Junk Bonds” to “High-Yield Bonds”. The investments in the fund didn’t change, but many more people invested in it.

● Following the crowd Almost all of us are creatures of fashion to some extent. If everyone else is getting into an investment, we’re inclined to join them. Besides, if it goes bad, we’ll have plenty of company. That doesn’t make any difference to a loss, though. It leaves you just as badly off as if you were the only one who suffered it.

You’re probably more likely to do well if you buy an investment when everyone else is selling, and sell when everyone else is buying, although even “contrarian investing” tends not to be as fruitful as just getting into the right investment for you and sticking with it.

● Emotional attachment You may have investments you have inherited or been given, and you would feel disloyal selling them. But wouldn’t the person who gave them to you prefer to know you have moved your money into investments that suit you better?

● Being overwhelmed with information Too much information can leave a would-be investor doing nothing. If you’re stuck, try to zero in on two or three good options, and divide your money equally among them.

● Fear of regret You may have good reason to get out of an investment — perhaps it’s too risky, or too undiversified. But you don’t want to sell unless you get more than the purchase price. This can lead to sticking with a poor investment for years. Once you’re in an investment, it’s irrelevant what you paid for it. The only question should be: is this a good investment for me, going forward?

● Not considering the whole portfolio Let’s say you’ve put some of your savings in shares or a share fund, but watered down that volatility by putting some in bonds. When you check how well you’re doing, don’t dwell on what’s happened to each type of investment. Concentrate on the results for the whole lot.

KiwiSaver

As discussed above, be aware of how some of these factors might affect your investment choices.