How investment rules and behavioural biases can combine to derail your portfolio

Every generation has its investment rules, which can later on make us look foolish. Yet fear and greed stay consistent, combining decisively to derail even the most experienced investors.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
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Over time, investors have witnessed extended periods of very different market conditions.  Talk to anyone invested nowadays and the focus is on boom and bust in financial markets; the bursting of the Dotcom bubble and the 2007—08 financial crash being the defining moments of the past 18 years. 

But it wasn’t always this way. My father’s generation in the 1980s and 1990s enjoyed a 20 year bull market, and took the view that the stock market would always provide, it being fine to spend your dividends but unwise to dip into your capital.

Going back further, my grandfather’s generation in the 1960s and 1970s had an absolute terror of inflation; fixed income should be avoided at all costs as the government of the day would crank up the printing presses. Before then, it was World War II, totalitarian governments, the Wall Street Crash and the deflation of the 1930s, which was fresh in the memory.

The point of this is to show that investing changes over time. A strategy that seemed a sure—fire winner in one decade can be a horrible loser over the next. Bonds can be your worst enemy, or, as we’ve seen over the past 20 years, your best friend. You might spend all your dividends, but look what happens to your wealth if your capital hasn’t grown since 1999 (vis the FTSE 100) and inflation ticks ever upwards year upon year.

Today you could look at US shares and tech stocks, expecting that those returns will be repeated again and again and again…

Behavioural biases are ever present

Selling at the bottom and fear of missing out (FOMO) are the two worst enemies for an investor. Selling at the bottom is easy to avoid, but only if you can afford to suffer capital losses over a potentially extended time period. For everyone else, the fear of ruinous losses could force their hand. A risk managed portfolio, such as an IG Smart Portfolio, that keeps some of your powder dry by diversifying across less correlated asset classes, will make the equity market big dipper that little bit easier to ride.

FOMO is rather harder to resist. It’s difficult to avoid the compelling stories that promise easy riches, often after the asset class has doubled more than once and when the ‘easy money’ has been made. Yesterday’s high returns just serve to borrow from tomorrow’s returns, but is that a reason not to invest in the theme of the day? In general I would say no, as no one has a crystal ball, but it is a reason to show considerable caution.

Position sizing is the key. There is no harm in owning speculative investments if the damage they do to your overall wealth is limited when they go wrong. A blockchain company might be the next great winner, or it could go to zero. As long as the position is modest, a realised loss won’t be harmful in the medium term as other investments should go up.

Within an investment portfolio, especially within a diversified portfolio of ETFs, there will be lots of underlying holdings that have done very well, sitting alongside others which have done poorly and have ‘looked cheap’ for years. When blended effectively (avoiding excessive exposure to any one asset class or market), ETF portfolios are diversified enough to be able to look through the noise of any one security going spectacularly right, or badly wrong, to be used as a long—term core portfolio. Security selection, with its associated risks and rewards, in those more concentrated positions, can be done on a share dealing platform.

This paragraph above describes a popular investment approach, the core—satellite portfolio. Protection from your inner investment demons in the core and exposure to your best ideas in the satellite.

It won’t work for everyone, as we don’t all have the knowledge, experience or risk tolerance to pick stocks. Nevertheless, at IG we facilitate an approach such as this, offering clients with £15,000 in a smart portfolio exemption, from the £24 a quarter share dealing custody fee.

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