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The cycle of market emotions and how to keep on track

13 December 2022 Sector Insights, Investment Styles, About Alliance Trust, How to Invest Marcus De Silva

Whilst investing is undoubtedly a rational and sensible approach to increasing our wealth, in truth, it is also an emotional rollercoaster complete with highs and lows worthy of any rock star’s autobiography. The cycle of emotions can be extreme, visceral, and confounding. When markets boom, we may feel shrewd and on top of the world; and yet, when they fall, so may we sink into the depths of despair.

The best investors learn not to ignore their emotions but rather to harness them and keep a keen eye on their long-term investment goals. Here, we look at why downturns cannot be avoided, the emotions they evoke and the impact these may have on long-term wealth creation, and six top strategies for reducing anxieties when investing in stormy markets.

What goes up…

Stock markets are, and always have been, and always likely be, a rollercoaster ride. This is because they are a collective reflection of forward-looking information regarding the health of underlying businesses and the economy, which changes almost daily.

There are times when everything is ticking along nicely: people are in jobs, politicians are making reasonable decisions, consumers are spending their cash, and companies and the economy are looking robust and growing at a nice clip. In this environment, share prices – a reflection of the present-day value of buying into a company’s future profits – will rise as expectations surrounding tomorrow’s world and its business environment become increasingly optimistic.

But then, something will upset the apple cart. Information will emerge highlighting that the economic picture in the coming months and years might not be quite as good as analysts and investors think. Perhaps a politician devises a ridiculous policy that has the potential to damage growth; maybe some inflation data emerges that indicates a central bank will have to keep choking-off economic activity by raising interest rates; or perhaps an unforeseen event occurs that blindsides investors - the pandemic or global financial crisis for example.

Glum news rattles investors and makes the certainty of the future cashflows of a business less so. As a result, readjustments about the future will manifest in stock market falls as the new information is folded into share price valuations.

And yet, over time, uncertainties tend to iron out, issues are generally solved, the future will likely look rosy, and share prices have the potential to rise once again. This is the cycle of stock markets.

As human investors in this soap opera, our emotions tend to mirror the highs and lows. How can they not: our money, for which we work so hard, touches every part of our lives.

This is how it may play out:

Impacting our wealth

Broadly, the impact of this cycle of emotions is to compel us to ditch the long-term time horizons we know we must apply with stock market investing, and at the extremes of price swings, either to panic and sell low or become too confident and buy high.

What is more, even if we only slightly change course, subtle adjustments to our portfolios can cause us to miss out on the best days of returns and have enormous effects on long-term wealth creation. We decided to quantify exactly how large an impact this may have – calling it the Impatience Tax.

Our model assumes that in 1992, we gave two hypothetical investors £10,000, to which they added £100 each month, and reinvested all of their dividends. Whenever the market dipped 5%, the Impatient Investor sold 25% of their holdings, and when it had recovered by 10%, they bought shares back. Meanwhile, the Patient Investor sat tight.

After 30 years, the Impatient Investor’s portfolio has grown to a value of £217,884, while the Patient Investor’s portfolio had ballooned to £410,272. This points to an Impatience Tax of £192,872 - an enormous hit to returns over the long term. Full details of this analysis can be found here.

It’s why we need to remain clear-eyed about our financial goals during these times, even if the paper-losses we see on our screens may cause us to feel anxious. Here’s our six top strategies for approaching volatile markets if emotions are running high.

  1. Think long term. Long-term investing comes with two enormous benefits. First, short-term fluctuations in the market iron-out over time. Second, returns have the potential to become increasingly juicy over time. This is because gains build upon gains – a wonder known as compounding. In fact, Albert Einstein, a somewhat intelligent man, described compounding as the ‘eighth wonder of the world’.
  2. Avoid crystallising losses. While lots of red flashing in our online brokerage accounts can causes our hearts to skip a beat, it is only a paper loss. As long as nothing has fundamentally gone wrong with your investment, it will likely recover soon. The worst thing you can do is crystallise losses by clicking the ‘sell’ button. Remember, most gains are made in the handful of days following a trough in the market – as evident by our calculations of the Impatience Tax.
  3. Use well diversified portfolio. When economic problems are popping up all over the place, and winning and losing regions, sectors, and stocks become harder to call, make sure your portfolio is nicely diversified rather than too concentrated in pockets of the market. Fortunately, a well-diversified portfolio such as Alliance Trust – invested in around 200 stocks around the globe - can help you as a core investment for any market condition.
  4. Keep investing. Perhaps counterintuitively, stock pickers tend to breathe a sigh of relief when markets go through a correction as quite often the companies that they’ve been following for a while become much better value. If you’re thinking as long term as you should be, then see downturns as a sure-fire opportunity to buy more of the stuff you love.
  5. Drip-feed investments. Investors can miss out on significant returns by trying to time the market and catch it at the bottom. This is folly. As the saying goes, it’s time in the market not timing the market. Instead, drip-feed your money into investments on a regular basis to ensure to catch the market’s best days.
  6. Avoid looking at your portfolio too much. Checking your portfolio during downturns like you would social media is much like doom-scrolling. Try not to too often – it will only encourage you to make mistakes if days are particularly grim.

Marcus De Silva is a Freelance Investment Writer

This information is for informational purposes only and should not be considered investment advice. Past performance is not a reliable indicator of future returns. The views expressed are the opinion of the Manager and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at November 2022 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. TWIM is the appointed Alternative Investment Fund Manager of Alliance Trust plc. Alliance Trust PLC is a listed UK investment trust and is not authorised and regulated by the Financial Conduct Authority.

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