When it comes to investing, taking a rational approach can sometimes make all the difference to the accumulation and preservation of wealth over short, medium and long-term investment time horizons.
Unfortunately, for some of us, there can often be a ‘behaviour gap’ between what we should do (rational approach) and what we actually do (irrational approach). This can occur when we allow cognitive bias to creep in and influence our decision-making process.
In a nutshell, cognitive bias is a systematic error in reasoning, evaluating, remembering, or other cognitive processes, which can occur due to one or a combination of the following:
- Too much information. For example, we may:
- Gravitate towards information that confirms our own beliefs.
- Recognise flaws in others more easily than we do ourselves.
- Not enough meaning. For example, we may:
- Project our own mindset and assumptions onto the past and future.
- Perceive trends or patterns even when looking at limited information.
- The need to act quickly. For example, we may:
- Favour the immediate, relatable thing in front of us.
- See things through where we’ve invested time and effort.
- The limits of memory. For example, we may:
- Discard specifics to form generalities.
- Store memories differently based on how we experienced them.
As you can see from above, cognitive bias can be factual, emotional or a combination of both. Some of the most well-known cognitive biases with regards to investing are confirmation bias, optimism bias, loss aversion, recency bias, and herding – we explore these in more detail in our article, ‘Mind Games: What’s Your Bias’. Importantly, this brings us to investment market cycles and investor sentiment.
Investment market cycles and investor sentiment
When considering historical data, no one asset or type of asset provides the best performance over all time periods. They tend to rise and fall at different times depending on economic, political and market factors. An example of this can be seen below.
|Annual Returns For Asset Classes*^
(Calendar Year, Ending 31st of December)
(2007 to 2017)
*Vanguard Asset Class Tool. Data from Andex Charts Pty Ltd.
^Past performance is not a reliable indicator of future performance.
With this in mind, trends and patterns do emerge with regards to assets and their movements over time. Importantly, the concept of investment market cycles is widely used to explain these trends or patterns and, where an investment market may be at a given point in time, individually and as part of a broader environment, for example, the economic cycle (and the investment clock).
In a nutshell, an investment market cycle consists of four cyclical phases. When overlayed with the share market, these phases can generally be illustrated as follows:
- Recovery/bull run (rising share price).
- Boom/peak (highest share price).
- Downturn/bear run (falling share price).
- Slump/trough (lowest share price).
When one investment market cycle ends, the next begins. Furthermore, depending on the market (and time horizon), an investment market cycle may last anywhere from weeks to years. For example, a day trader may see several full investment market cycles over the course of one day, whereas a long-term investor may see one full investment market cycle last 15-20 years.
In light of this, in an attempt to get more for their investment dollar, some investors will try to time the investment market. Namely, aiming to invest when the investment market is low and exit when the investment market is high. Unfortunately, when this is coupled with ‘behaviour gap’, an investor will often have:
- Short-term memory. They either fail to recognise the cyclical nature of investment markets or forget to expect the end of a current investment market phase.
- Herd mentality. They hop on the investment bandwagon, following the actions of a larger group, whether those actions are rational or not.
If left unchecked, this can lead to not only a rollercoaster ride of emotions as they move through investment market cycle phases, but can also culminate into the well-known phrase ‘buying high and selling low’. An example of this can be seen below.
|The Investor Sentiment Wheel
The Cycle of Investor Sentiment versus The Investment Market (Shares) Cycle
|Investment Market Cycle Phase|
|Flow||→ → →||→ → →||→ → →||→ → →|
|Action||Watch & wait||Buy & increase position||Average down & hold||Sell|
Please note: Investment markets can be unpredictable. As such, it can be extremely difficult to pick the top or bottom of an investment market cycle – this can mean missing out on some of the best performing days in the investment market and have flow-on effects for the long-term performance of an investment portfolio. With this in mind, a ‘buy and hold’ and dollar cost averaging strategy can be a vital consideration.
When it comes to investing, taking a rational approach can sometimes make all the difference to the accumulation and preservation of wealth, both inside and outside of superannuation. Consequently, it’s important to keep in mind good investor behaviour traits. For example:
- Setting clear and appropriate investment goals and objectives.
- Developing an asset allocation for your investment portfolio which takes into account,
- Your financial situation, goals and objectives,
- Your tolerance to risk and investment time horizon, and
- The need to diversify your investment portfolio to avoid unnecessary investment risks.
- Staying committed to your investment strategy (and setting aside emotions) through times of investment market uncertainty and notwithstanding the actions of the investment market herd.
- Working with a trusted financial adviser to help keep you on track.
If you have any questions regarding this article, please do not hesitate to contact us.