Investors tend to do hasty things when markets tumble. They
often sell in a panic, miss the inevitable recovery and line up to repeat the
process at the next pullback. Many of those pullbacks—notably the 1907, 1929,
1987 and 2008 stock-market crashes—have taken place in October. Recently, the
S&P 500 fell 9.8% in price from its September high through Oct. 15. That
hardly is a crash, and markets have since rebounded, but it was enough to put
fear back into the picture and tempt more bad behavior.
Here are four lessons investors should heed to avoid falling
into old traps.
Changing your mind
about an investment is very hard.
Minds, like water, follow the path of least resistance.
Convincing yourself to believe something that isn’t true can be easier than
admitting you were wrong.
This is common in investing, says Elliot Aronson, a psychologist
at the University of California, Santa Cruz. We convince ourselves that we made
the right decision by making up stories for why we should have been right, even
when we clearly weren’t—claiming the data are wrong or that our prediction was
just early.
Anyone hooked on a specific style of investing—or a
political party, or a philosophy—is at risk of this bias. You can prevent it by
embracing reality and becoming an honest reader of data.
What we think is
tomorrow’s biggest risk rarely is.
If people are talking about a risk, they have time to
prepare for it and markets have time to reflect it in prices. That makes it
less risky.
What really is risky is the stuff nobody is talking about,
because that is what nobody is prepared for. You should be skeptical of
investing around big, bold ideas. You probably are wrong about them, and even
if you are right, the market is likely pricing in the possibility already.
Have a long-term mind-set and let your investments run
throughout the economy’s ups and downs. Markets reward patience more than
brilliance.
Taking advantage of
opportunities is harder than it sounds.
The problem with taking advantage of current opportunities
is that we have no idea how appealing future opportunities might become. There
is a long history of pundits calling a bottom, followed by months or years of
things getting worse.
You can’t time a bottom perfectly. Since opportunity rises with
the severity of a market crash, I have learned to be more judicious with my
cash. This means being less aggressive about buying when the market falls 10%
or 20%, and having extra cash for the possibility of stocks falling more, when
opportunities are greater.
Most investing is
simple, but we complicate it.
Companies earn a profit. When investors are in a good mood,
they pay up for that profit. When they are in a bad mood, they pay less. Future
stock returns will equal profit growth, plus or minus the change in investor
attitudes. That really is all that is going on in the stock market. But we
complicate it, scrutinizing every market detail for evidence of what is coming
next.
A sensible way to invest is to assume companies will earn a
profit, and assume the amount investors will be willing to pay for that profit
will fluctuate sporadically. Those emotional swings will balance out over time,
and over the long run the profits companies earned will accrue to investors’
pockets.
Everything else—what stocks might do next quarter, or when
the next crash might come—can be needlessly complicating. Investors should
learn to take the simple route.
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