With ongoing uncertainty clouding our economy, the past six months market activity have highlighted two common errors that investors have been making, both of which can be remedied but both of which influence how their portfolios have performed.
The first is a misunderstanding of the way in which investments compound over time, and the second is allowing our emotions to take over when choosing how to rebalance portfolios.
Many investors tend to view returns arithmetically, rather than geometrically, as they prefer to add numbers together in their heads. Yet investments compound from one period to the next. We explain how in the below example:
In the fourth quarter of 2018, the UK stock market fell by 13.7%. But as of April 2019, it had rallied by 13.9%. 13.9% is more than 13.7% so investors are up by 0.2%, right? Wrong. Investors are in fact down by 1.7% in this period.
If you had £100 at the start of 2019, then your investment would indeed have gained £13.90. However, if you had invested the same £100 at the end of 2018 when stocks fell, then that £100 would have suffered the 13.7% loss, taking it to £86.30. In this situation, you now only have £86.30 at the start of 2019 to benefit from the 13.9% rise. This takes your total investment back to £98.30, less than you started with or if you had waited until the start of 2019 to invest your £100.
Misunderstanding the effects of compounding can not only cause investors to miscalculate their returns, but also cause borrowers to underestimate how much it will cost to repay a loan.
As mentioned above, the fourth quarter was a tough time to be invested in the stock market as values fell sharply. As humans, our emotional reaction could be to ‘jump ship’ and sell, alleviating our fear of suffering further losses.
However, at Finura, one of the key factors that we consider when managing our client’s portfolios is their emotional instincts. We are often hard-wired to act on our urges to buy and sell when the market changes, basing our decisions on recent past performance, rather than our overall long-term objectives.
One way to overcome some of our emotional bias is to follow a rebalancing policy. If you have a diversified portfolio, then you will likely have investments in a variety of asset classes. If one asset class outperforms the others, its weight in the portfolio increases. Rebalancing involves selling some of that increase and reinvesting the gains into those that have performed less well. However, instinct would suggest that reinvesting into lesser performing assets is the wrong decision; yet the reality is that rebalancing could have an overall positive effect on your investments in the longer term. Your financial adviser can assist you in making these decisions.
Articles on this website are offered only for general information and educational purposes. They are not offered as, and do not constitute, financial advice. You should not act or rely on any information contained in this website without first seeking advice from a professional.
Past performance is not a guide to future performance and may not be repeated. Capital is at risk; investments and the income from them can fall as well as rise and investors may not get back the amounts originally invested.
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