Decision making amid the ups and downs of a sideways market
Shakespeare wrote that life was a tale told by an idiot, full of sound and fury, signifying nothing. He could have been writing about the sharemarket - up one day, down the next, going nowhere. And that leaves investors in a quandary.
Most investors understand that shares provide better returns in the long run than cash or bonds, but the fear of short-term losses stops them acting on it. When markets are choppy with no clear direction, investors tend either to hesitate on the sidelines and miss opportunities, or sell too early to avoid a loss.
Either way, the motivation is fear, which results in poor decision making. "The most valuable thing I have learnt over more than 30 years of investing in stocks is that great investors think differently. They understand that investing is about managing uncertainty," professional investor Colin Nicholson says. In his latest book, he discusses the common decision-making traps investors fall into and how to avoid them, drawing on the field of behavioural finance. Early research by Daniel Kahneman and Amos Tversky found people place greater value on avoiding losses than on making gains. Not only that, but they prefer a small certain gain to a larger potential one.
Further behavioural finance studies have found that an aversion to losses caused people to sell their winning stocks too early and hold their losers too long in the hope the share price would recover. Nicholson says investing should be managed like a business. Some decisions work out and some don't: if an investment doesn't work, sell; if it works, let it continue. Unfortunately, most people do the reverse.
"We are in a sideways market at the moment, which is the most difficult of all to invest in," Nicholson says. "Any fool can make money in a rising market. And if investors are half-smart they can avoid falling markets. But in a sideways market you need to be a stock picker and you need to preserve capital."
A practical way to achieve this is to use stop losses. Nicholson says the key attributes of great investors are patience, discipline and perspective. "People get caught up in the psychology of the crowd," he says. "If you can step back and get some perspective it helps."
Reading about market history is helpful, but before you invest you need a plan.
"One of the ways to deal with inertia and fear is to have a written investment plan that sets out how you select stocks and manage your investments, so no matter what the market throws at you, you know what to do," Nicholson says.
Think Like the Great Investors: Make Better Decisions and Raise Your Investing to a New Level, by Colin Nicholson, 2013, Wiley.
What is a stop-loss?
A stop-loss is an order with a broker to buy or sell a stock when it reaches a certain price. This is done to limit your loss if an investment doesn't work out.
Say you buy Woolworths shares at $30 because you think it is a good long-term investment and has been oversold. But what if you are wrong and the share price keeps falling? If you set a stop-loss at $27, your shares will be sold automatically if the price drops below that level, containing your loss to 10 per cent. The level you set will depend on the amount you are willing to risk.
You can also adjust your stop-loss upwards to protect your profits. If you set your stop-loss at 10 per cent and Woolworths surges to $40, your shares will be sold if the price drops back below $36. That way, you pocket a profit of $6 a share and protect yourself against further falls.