Market crashes and downturns are inevitable in any economic cycle. Even great investors such as Warren Buffett and Jack Bogle have admitted to making costly mistakes throughout their careers. The difference between expert and novice investors, however, is that experts learn from their mistakes and use their insights to improve their processes.
Mistake 1: Don’t trust current data sets without proper scrutiny
Traditionally, returns from equities are higher than those from cash since they tend to price in a risk premium. From time to time you could expect lower risk assets like cash to outperform equities, but you would not expect this pattern to persist for extended periods of time. Equities have been under pressure for a while, which has skewed the traditional risk-return dynamic in asset classes. The underperformance of equities has also filtered through to more historic returns in funds, making more conservative mandates outperform more aggressive ones. If you were to rely solely on current data sets, you could conclude that a more conservative strategy is the best bet, even though current patterns are contrary to what we would traditionally expect and such a strategy may in fact not be suited to your needs. Since equities have underperformed in the short to medium term, we have noticed many investors moving their investments from growth assets like equities to more conservative products like cash.
Will the next five years look like the past five
The key question investors should ask themselves now is: “Will the next five years look the same as the past five years?” Anybody can look at the same data sets and see that conservative managers or strategies are currently performing well. But an experienced and knowledgeable manager will know that the current trend is not the norm. Older data sets can also lose their relevance. Therefore, you cannot simply rely on data alone to make decisions. A mixed bag of experience, expertise, industry knowledge, different viewpoints, and different strategies puts you in a better position to make investment decisions. Statistics can be deceptive, and it is critical that the hypotheses that data presents are tested by experienced research teams. When data works for you it’s great, when it deceives you, it can be disastrous.
The table below highlights how global equities have outperformed all other asset classes over a five- and 10-year period.
Mistake 2: Excessive changes to asset allocations in portfolios
We believe investors start making mistakes when they are no longer making incremental tactical shifts to their portfolios (as part of a disciplined process and aligned to their overall investment philosophy), but are rather making excessive and emotional changes to their portfolio in response to data. For example, when investors move their capital out of equities completely into cash – usually timing the market incorrectly. While most people understand the risks of investing in equities, investors need to understand that investments in cash run the risk of not beating inflation over time. Since the aim of investing is to grow your wealth in real (after-inflation) terms, cash as a long-term investment is arguably a high-risk strategy.
Periods of underperformance are factored in
Humans inherently feel the need to act when things are not going according to plan. However, investors need to consider that when investment managers work on long-term expected returns, periods of underperformance are usually factored in as part of our decision-making process. When we work on 40-year projections for equities, for example, we make provisions for several corrections to take place over this period. Volatility and market corrections are completely normal stock market behavior, and therefore we employ strategies that can help to smooth periods of underperformance over the long term.
Mistakes are a natural and valuable part of your learning curve as an investor – provided you are willing to learn from them. Doing so can help you trim losses in the future, and viewing them as a learning opportunity is often what sets the professionals apart from the amateurs. For the average investor, the best route may well be to stick to a financial plan that was devised with a specific goal in mind. The highest risk of a financial plan’s failure is not from anomalous performance periods, which could be expected to correct in the long run. Rather, it is from deviating significantly from the plan and abandoning proven investment philosophies along the way.