An Example of How Reacting in Fear Can Hurt Portfolios

During the bull run following the Tech Bubble, many investors were reluctant to invest in equities. More than likely, there will be many investors who will feel the same way for years to come. When left to emotions, investors are invariably always a step behind and this can really hurt portfolios because what tends to happen is that when people start to feel confident about the markets again, the markets may be ready for their next downturn. So these investors basically get into the markets at just the wrong time, and leave at just the wrong time too.

An Example

This chart shows the performance of the TSX from a random period of time. I also plotted a hypothetical GIC type investment which shows up as a straight line with a shallow slope.

When the TSX had this 14.52% correction, you can be sure many investors ran for the hills and purchased money market funds or GICs. But look what happened after the correction. The TSX came back up. Let’s plot a portfolio of an investor who was invested in the TSX and then switched to a GIC out of fear during the correction.

If the portfolio started with $10,000 (and not assuming transaction costs or management fees, etc.), than the buy and hold investor basically doubled their money. The person who switched out of fear gave up half of their potential returns with an ending amount only slightly above $15,000.

Always A Step Behind

But the real problem is that now this investor might look at this chart and say, “Yup, equity is the way to go – I’ll switch back now.” If we fast forward the chart, and the investor then switched back to the TSX his total portfolio value today might be back down to $10,000 as the TSX soon entered a bear market after the end of the above charts.

The investor is now thinking, I was right all along – should’ve stayed in GICs. And you can see how the vicious cycle can repeat.

It is important to stick to a plan. By just holding GICs the investor would be better off than constantly switching between equities and GICs at the wrong times (like many investors are inclined to do due to emotions.)

If you are going to commit to a long term investment plan, you can’t focus on the short term performance if you expose yourself to equities. As Canadian Capitalist put it, “…the higher returns from equities come from bearing the risk of holding stocks through times such as this.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 12 comments
  • Canadian Capitalistc

    Thanks for the link Preet. Unfortunately, it seems to me that investors would continue their market timing ways.

  • Michael James

    Well said, Preet. I think people have a hard time seeing the connection between their market timing efforts and the results you describe, but this is the logical consequence.

  • Mark Wolfinger

    But, if you are going to ‘expose yourself to equities,’ you can hedge your positions with options – preventing large losses.

  • Preet

    @CC – I would put money on it!

    @Michael James – Thanks, I think I was inspired by your recent posts on behavioural finance. :)

    @Mark – hedging with options is certainly a viable solution for many investors – especially if it provides peace of mind.

  • Joe Dolan

    Excellent post!

  • Joe Dolan

    Preet, I have ie7 and windows xp. it now says on your site that i require AC_ Runactivecontent.js. How do I get that? I’m not very good with computers. Thanks for your help—-Joe

  • Acorn

    Hi Preet,

    You are right with corrections… But, these days many people are recovering their savings (not the money, which they lost with “investing”) that were deposited in the Bear Stearns, not buying new cars and stereos. So it is hard to expect that they will drop everything and start to buy stocks pushing the market up. Well, I have to say about market that “this tine is different…”

  • q

    Preet

    I am also getting a warning dialog about AC_ Runactivecontent.js

    q

  • Preet

    @ Joe and Q re: the AC_Runactivecontent.js error message – I get that on my work terminal too, but not when running Firefox. I haven’t changed anything on the site so I’m stumped. The only thing I could suggest is trying out a different browser. :)

    @ Acorn – I find that the market is moved more by institutional investors who try to gauge future earnings through financial statements and other indicators – the retail investors tend to be more reactionary to price movements. Either way, if the consumer is not spending then earning will be depressed and the same result will occur (i.e. stock prices not getting pushed up).

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