How to avoid behavioural traps in strong markets

By Kajanga Kulatunga

Portfolio Specialist, NAB Asset Management

Markets are reaching all-time highs in a range of asset classes. Thanks to the strong rise in the last three years, returns over most periods going back even a decade are looking solid.

Environments like this can breed overconfidence, and tempt investors into taking undue risk in their portfolios. For many investors, it may be helpful at this point to pause and reflect on what could have the greatest impact on their prospective returns – their own behaviour.

Here are three things investors should be aware of.

1. Don’t get overconfident. As many decisions investors have made over the last five years have come right, they start feeling smart and become more confident about their ability to predict where returns will come from. But these investors are not alone in having done well in this period – all asset classes have provided strong returns over the last five years. And strong performance of investments during a rising market isn’t an indicator of investment skills. It’s how these investors behave and how their investments perform during times of market distress that are the sign of a good investor.

2. Don’t underestimate the benefits of diversification. Diversification may sound old fashioned, and returns from balanced funds may appear ordinary compared to the hottest investment of the moment. But in reality, true diversification across a number of sources of risk and return is both a smart strategy for spreading investment risk and difficult to achieve by investing directly.

3. Don’t be swayed by recent events. We are wired to give undue weight to the most recent events, but investment mistakes occur when decisions are made based on recent market events.  For example, in 2010 the common view was that Australia could do no wrong, so Australian shares were the best asset class to own. With the GFC still fresh in the minds of many investors, global shares were shunned as being “too risky.”  In hindsight, unhedged global shares would have provided far better returns for less risk than Australian shares.  Similarly, now that unhedged global shares have had three very strong years of returns, many investors are interested in them, yet the best returns have probably been made. Instead of chasing yesterday’s winners, and reacting to the most recent and dramatic news, it’s probably best for investors to remain patient and stick with the strategy that’s been determined is most likely to achieve their long-term goals.

We often go to considerable efforts to maintain the belief that we’re in control in situations where we really aren’t. It’s the same for investments: no one truly knows what lies ahead in the market. The best investors can do is plan for a range of different possible outcomes. If most likely future paths point towards not achieving their goals, they may need reset their expectations – revise their goals, or perhaps change their savings plan to make up for the difference between what they will need and what the portfolio may provide.