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Investment lessons from the crisis

Periods of extreme market turmoil are rare but regular. Here are eight investment lessons to relearn from this crisis to prepare for the next one.

An emergency fund is your first investment priority

Holding six months of expenses in cash can seem wasteful when markets are booming. But many people are now finding out how essential such a safety net is when things go wrong.

Markets go down as well as up

Stock markets are not a one-way route to riches. To reap the higher long-term returns from equities you have to be prepared to withstand the trauma of your investments temporarily collapsing in value by between a quarter and half once a decade or so. Your investment strategy needs to reflect how much you can stomach this.

You won’t know how you’ll feel until it happens

So how did you cope with the recent market turmoil? Were you calm or did you freak out? Did you feel compelled to change your investments? It’s tough to know how you’ll react to a bear market until you experience it. So when you do it’s a great learning opportunity. Were you taking more risk than your psychology could withstand, and so do you need to introduce more cash or bonds into your portfolio? Or perhaps you’ve come through it ok and feel comfortable with a higher weighting to equities? Reflect on what your experience means about your attitude to risk and how this should affect your investment strategy.

Diversification works

Not all assets move in the same way at the same time. Global equities have fallen less than the UK market. Bonds held up as equities collapsed. Spreading investments across markets and asset classes reduces risk.

Property isn’t a free lunch

When markets are rising and interest rates are falling, it’s easy to get rich off the back of mortgaged buy-to-let property. But occasionally the risks come home to roost: tenants don’t pay, landlords can’t evict, property markets freeze, and interest rates rise (ok not yet). Over-exposure to heavily mortgaged property can lead to riches but also to ruin.

Don’t invest in things you don’t understand

Exotic stuff has a habit of blowing up in a crisis: open-ended funds holding illiquid property investments; leveraged synthetic commodity ETFs backed by an investment bank counterparty. If you don’t understand what it is or how it works, steer clear.

Invest based on your plan, not the state of the market

Just because markets have fallen 25% doesn’t mean equities are going to bounce back. Just because the economy is tanking doesn’t mean that equities are going to fall  further. We don’t know whether markets will fall, bounce back, or go sideways over the short term. But we do know that over periods of two decades or more equities and property normally produce much higher returns than lower risk assets like cash or bonds. If you’re saving for the long-term, then these assets should form a major part of your investments regardless of what’s happening in markets right now – but probably no more nor less so than in January. Stick to the plan: a fit-for-purpose plan before the crisis should still be fit-for-purpose now.

Most of us need help to be successful

All of us are subject to behavioural biases when it comes to investment. Optimism, loss aversion, short-termism, familiarity and a host of other biases make a mockery of our claims to be rational.  These biases can lead to serious mistakes and major financial losses. But we find it very difficult to see our own biases and errors. So consider getting help. Seek a coach or adviser who can understand what you’re trying to achieve in life, where you’re coming from emotionally, and can help you figure out how to match these two factors with your approach to investments. Few people in life reach the top of their game without a helping hand. Why should investing be any different?

 

Read more from Tom at http://www.linkedin.com/in/tom-gosling/