To make good investing decisions, don’t look to momentum

It is a good time in the market cycle to be reminded of the momentum investor bias. This bias is really a sequence of responses to movements in markets, that can seem quite rational, but if followed can reduce your returns and potentially leave you worse off than when you started.

For this to make sense, we need to agree on the principle that investment markets go up over time, but not in a straight line. Another way to say this is that time reduces volatility and the likelihood of losses and what looks like bumpy markets across a short time period like a month, can be smoothed out when looking at a long time period, like ten years.

What in the short term might look like this:

In the long term will look more like this:

Therefore our responses to short term market movements should be to look at our investments and what is happening in the world relative to our goals and the timeframe of those goals. If your key goal is 15 years away, a short term fluctuation now might be irrelevant.

The momentum investor bias can lead us into wanting to make rash decisions when investment prices go up or down.

The image below shows some of the bias responses that can take over from good decision making.

 If you look at the worst-case scenario in this illustration, our hapless investor liked an investment (the green comments on the left), but waited until it was ‘proven’ and bought near the top of the market. They panicked at the first sign of market volatility and then as the investment moved through the market cycle and the downturn, they fell into the trap of thinking the prices would fall forever. After much hand-wringing they finally sold right near the bottom of the market before – inevitably- the prices recovered. The alternative path would have been to invest in an asset that was appropriate for their goals and plans, and to not sell them at all. Over time the asset would have increased in value. This is of course hypothetical, but it illustrates how momentum can lead us to make reactive decisions.

When we shop, we are quite comfortable with the idea of buying items when they are on sale rather than when they are at their maximum price. When it comes to investing though, if we follow the momentum investor bias, we are much more inclined to wait until an investment has already gone up (increased in price) before investing.

It is not difficult to understand the rationale. If we wait until something has increased in price, it feels like a proven and safer investment- it has a track record. What is often means though is buying at the top of the market. One of the most often repeated phrases when giving financial advice is that past performance is no guarantee of future performance. Just because an investment has risen in value does not mean it will continue to rise at the same rate.

Following this pattern, the investor bias kicks in again when prices drop, meaning we may be less likely to buy, even though that asset may be considered as being ‘on sale’.  In fact we may feel inclined to sell. The momentum investor gets increasingly worried as prices drop.

Investment theory states that for investment success we should buy low and sell high- the opposite of what we have described above with the momentum driven investor. In practice this is a difficult, and almost impossible thing to do.  We maintain it is not possible to time the market, consistently and accurately. As an extension of this, we believe there is much more value that you can add to your investment (at a considerably lower risk) by consistently following a structured plan across market cycles, than there is in trying to time peaks and troughs.

It is important to remember that the purpose of investing is to achieve your long-term objectives. Investing is a means to an end, not the end in itself. So, the most important question is not whether there is a short-term opportunity but whether your investment structure and investment plan are aligned for you to achieve your goals.

If your focus is the long term, focus on the long term.

Being aware of these investor biases can help you to stay on track and avoid making investment decisions that can hurt your returns. Seek advice from qualified professionals: we are doing this every day and can help you to achieve your goals.

Contact us at info@blackswancapital.eu, or go to our website www.blackswancapital.eu where you can find lots of useful information to help you make sound investment decisions.