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Investment Strategy
Saturday, December 1, 2012
Why you lose by trying not to lose

Most people have quite a clear attitude towards losing money from their investments: they don’t like it, and for good reason.

“However, investors are urged not to attempt to avoid short-term losses by trying to time the market as this often leads to bigger and more permanent financial losses,” says Anil Jugmohan, CFA, Investment Analyst at Nedgroup Investments. The accompanying graph shows that, along with greater losses, an even bigger gain is subsequently required to recover. The horizontal axis shows a hypothetical initial loss suffered by the investor while the vertical axis displays the corresponding gain needed to recover.

“Investors therefore feel that avoiding such a loss in the first place will automatically hold them in good stead to achieve better than average long term returns. While correct in principle, this emotional response unfortunately results in many kinds of sub-optimal actions such as trying to time the markets or investing in assets that are not really suitable for your long term goals,” explains Jugmohan.
Investors generally dislike losses twice as much as they enjoy making gains of the same rand amount. “In other words, a loss of R1 000 hurts twice as much as the pleasure of making a gain of R1 000. However, this emotional reaction often leads investors to make destructive financial decisions,” he says. He also says that one of the worst things that an investor can do is to move their investments into cash after making a significant loss, since they are then likely to lose out on any subsequent recovery.
“Indeed, savvy investors who buy low and sell high tend to get more optimistic as broad market price levels fall and in fact use these periods of elevated stress to increase their holdings of equities at the expense of fearful market participants who are instead trying desperately to sell out.”
Jugmohan says that moving into cash during periods like these also means their expectations of potential future return scenarios are not properly informed at the outset. To avoid this, he urges clients to educate themselves about asset class behaviour as well as how to structure an investment portfolio for the best long run results before committing any capital.
“A helpful hint is not to invest based on expectations of recent performance momentum continuing. The better the returns, the greater impetus you will then have to invest, while the poorer the returns the worse you feel about remaining invested. In the words of Warren Buffett: “Be greedy when others are fearful and fearful when others are greedy.”
Jugmohan concludes by saying that in order to overcome the power of their emotions in reacting to losses, investors should first clarify their objectives by using a rigorous financial planning framework or by enlisting the help of a professional advisor. “After matching one’s goals to the appropriate investments it is critical to stick to that strategy throughout the ups and downs of the market. As difficult as all of this may seem, the longer term benefits far outweigh the reasonable costs of adopting this approach.”

Copyright © Insurance Times and Investments® Vol:25.12 1st December, 2012
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