The current uneasiness in markets seems to suggest that volatility may shortly rear its ugly head yet again – more often than we have grown accustomed to over recent years. On this basis, I thought it an appropriate time to address the fact that even caution can be an investment risk, no matter how counter-intuitive that may seem. Whilst the last thing we wish to advocate is ‘throwing caution to the wind’ and treating asset markets as if we are back in the Wild West, there is no doubt that caution could potentially be as hurtful to a portfolio as being too aggressive, if approached incorrectly. What many investors forget when consistently promoting caution as that a preventative measure against losing money is that from the perspective of the future value of your investment, missing out on potential upside hurts every bit as much as participating in downside.
The source of the problem seems to come down to the Prospect Theory (also known as the ‘loss-aversion theory’), which states that “losing feels worse than winning feels good”. Looking at a practical example; the amount of utility gained from receiving US$50 should be equal to a situation in which you gained US$100 and then lost US$50. However, most people view a single gain of US$50 more favourably than gaining US$100 and then losing US$50, as illustrated in the asymmetric value function chart.
The theory is that this potentially makes investors behave irrationally. To further illustrate this, think of it as a binary choice – holding cash or holding equity. Even though the past 20 years was not a particularly favourable period for equities, cash in US Dollars yielded 3.03% annually, whilst the S&P500 Index would have returned an annualized 8.42%.
Being overly cautious is an emotional bias, with a huge opportunity cost. In the world of investments it is the equivalent of insisting on having your money invested and, at the same time, always feeling that a market correction is imminent and aligning your portfolio accordingly. In short, it’s hard to justify investing at all if you consistently believe you will be losing money, and waiting for a better entry point.
Although it is extremely hard, the best solution for your future wealth is to try and remove emotion from the equation. This does not mean abandoning caution entirely, but rather spending the appropriate amount of time to assess how much risk you can afford to take and how much capital you are prepared to commit. Once this has been established, a well thought-out, structured plan can be implemented.
The trick is to try and not get too involved in the hype the media creates around short-term market movements (particularly on the downside), which is, after all, their ‘bread and butter’. A highly effective way to mitigate these fluctuations, something we at MitonOptimal whole-heartedly believe in and which is a central pillar of our investment philosophy, is diversification across different asset classes, in the correct proportions, based on where we find ourselves in the economic cycle (long-term), with some tactical deviations based on the business cycle (shorter-term), all within appropriate risk limits. Given how markets have evolved, however, it is probably best to leave this to a professional, rather than potentially gambling with your future wealth based on partial information.
Article by Simon Morrison – MitonOptimal