Investment rule #2 – It’s all about managing risk and emotion

//Investment rule #2 – It’s all about managing risk and emotion

Investment rule #2 – It’s all about managing risk and emotion

 

Many seasoned of investors were startled – and millions were shocked – by the market’s plunge in 2008 and the first quarter 2009.

I was one of them (more shocked than startled) and I am sure you were too.

The decline is best shown by the following graph of the European STOXX 600 stock market index.


Source: Onvista.de
(The STOXX Europe 600 Index represents large, mid and small capitalisation companies across 18 countries of the European region)

Banks and asset managers attracts you with how much money you are going to make, how secure your investment will be, and how life will be easier and worry free as soon as you have bought one of their products.

It is a really attractive message I am sure you would all like to accept.

But reality is different and we should all know better.

Today I am going to tell you a hard truth about investing.

It’s probably the worse thing I can say if I want to attract you as a subscriber, but I have to say it.

I will start with the bad news and then help you to manage it and maybe even profit from it.

Here it is…

If you invest in stocks, either directly or through a fund, you will sometimes lose money. This is not a remote possibility. It’s a certainty.

Even if you eventually sell at a profit there may be periods in which you will lose money. And if you were invested in the market in 2008 or the first quarter 2009, you most certainly lost money.

The problem is, after a time, usually two or three years of good performance, investors start acting as if the market can only go up. Then, without warning, along comes a sudden correction that in a short period of time wipes out most if not all of your gains from the previous months or year.

Welcome to the real world of investing!

These declines that happen every now and then are perfectly normal market behaviour. It’s called a drawdown, a drop in market value of a company or the market overall.

You are most likely familiar with graphs that show investment returns over time. The lines sometimes go up and sometimes go down. Drawdowns are the lines that go down.

To give you an idea of the size of drawdowns you can expect I have put together the graph below.

It shows the monthly percentage change of the European STOXX 600 index over the 20 year period form 1989 to 2009.

 

 

European Stoxx 600 monthly returns

 

The graph is very helpful as it shows you what you must be prepared for if you invest over the long term.

Even though the monthly movements looks quite wild the average monthly movement was +0.5%. And the biggest monthly movements -14.1% and +13.5%.

Looking at the graph what do you think the index return over the 20 year period was?

Take a guess…

It was 168.1%.

So overall you would have made money but the road was quite bumpy.

Getting back to the graph.

What is important for you to note is, without exception, every year there were months with price decreases. 1993 and 1995 were relatively calm years with only small drawdown’s but 1990, 1998, 2002 and 2008 gave investors quite a rollercoaster ride.

If you thus look only at average price of 0.5%, you may get a false sense of security.

It is mathematically accurate – but misleading.

A monthly average gain of 0.5% should be a pleasure to achieve. But that average includes 10 months of double-digit losses plus four months of losses over 9%.

Another observation about averages: You might not ever find them in real life. There was only one month that looked like the average and that was September 2007.

One out of 251 months.

 

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So the lesson from this article is that short-term losses are inevitable if you want to have long-term gains. And how you manage these losses emotionally is one of the most important keys to your investment success.

If you experienced panic or severe stress in 2008 and 2009 you should really re-evaluate how much risk you are taking. Getting high returns are important but are they really worth it if your health suffers because you are sleeping badly or are constantly stressed.

The smart thing to do is to reduce the amount of risk you are taking and get back your peace of mind. This is best done in calmer times because if market movements already have you stressed you may find it difficult to make rational decisions.

 

So what can you do to prepare yourself for drawdowns?

The absolute best thing you can do is to develop a good investment plan and follow it.

You can read more on how to develop a sound plan in the article Do you have an Investment Plan?

And an investment process in The best investors have this… Do you?

The right plan will ensure that you portfolio is diversified so that you do not have to worry about the short-term movements of any company or industry sector you are invested in.

True investment success is really about managing risk and your emotions.

To find out if you have taken on too much risk answer the following:

  • Does the financial news make you worry about your future?
  • Have you lost any sleep over your investments?
  • Do you feel compelled (not curious) to check your portfolio on a daily basis or watch financial news?

If your answer yes to any of the three questions you may have taken on too much risk. If you have answered yes to all three you definitely have to change your investments as you have taken on too much risk.

So in summary

If you want to be a successful investor, you have to learn to effectively manage risk and even more important your emotions.

Making sure you have an investment plan and process is the best was to do this.

Your unemotional analyst