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News Bulletin : ADA News Bulletin November 2011
39 NOVEMBER 2011 Compiled by Michael Lannon investment insight The cycle of mARKET EmOTiOnS www.2020directinvest.com.au/ada | 1800 352 021 100% entry fee rebate on managed funds It has been a roller-coaster ride for investors over the past six months as they cope with the extreme volatility caused by the continuing uncertainty about high levels of government debt and the health of the global and domestic economy. The stock market acts like a barometer of future events and attempts to predict what will happen to share prices a year from now. In essence, stock market investors are buying shares in real businesses and the future prospects for the earnings of those companies determine what value is placed on those shares. When viewed historically, periods of market uncertainty and volatility have proven to be good times to buy just as periods of euphoria and boundless optimism have been the right times to sell. It is hard to swim against the tide and invest in a manner that is contrary to mass opinion but many of the world’s most successful investors have done just that. In periods of extreme volatility, investors become very nervous and often make poor decisions based more on their emotions than on rational thoughts. There are few things more emotional than your financial wellbeing and it is quite difficult to keep your emotions in check when the media keeps you focused on the short-term, with sensationalist headlines forecasting doomsday scenarios. If you read my article last month, you will recognise the following quote attributed to legendary investor Warren Buffett about how emotions can undermine your thought processes: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework.” With this in mind, I will attempt to explain the ‘cycle of market emotions’ to help put the current environment into perspective. The cycle of market emotions is one of the most important road maps for investors as share prices move through periods of boom and bust, of rise and fall, and of calm and volatility. As investors, we all start out with optimism. We commonly expect things to go our way, or, expect a positive return for the risk of investing. As our expectations are met we become excited about the possibility of even greater returns and the excitement becomes Source: Russell Investment Management Limited thrilling as the returns exceed our expectations. We are at the top of the cycle when we experience euphoria. But it is at this point that we are at the point of maximum financial risk. When we believe is everything that we touch turns to gold, we fool ourselves into believing that we can beat the market, that we cannot make mistakes, that excessive returns are commonplace and that we can tolerate higher levels of risk. This euphoria was experienced by many investors in the last property boom in Australia and in the strong double-digit gains in the share market in the lead-up to the GFC. Share prices and property prices were rising substantially each year and many investors expected this trend to continue indefinitely. The second phase of the cycle occurs when the market stops meeting our new lofty expectations and begins to turn. At first, we anxiously watch the market for any signs of direction. Our anxiety turns to denial and then quickly to fear as the value of our investments declines. We start to act defensively and may think about switching out of riskier assets like shares to more defensive asset classes such as cash and fixed interest. Many Australian investors have done just that over the past year as uncertainty about the future is replaced by fear. In the third phase of the cycle, the realities of a bear market come to the fore and we become desperate. Many of us panic and withdraw from the market altogether – afraid of further losses. Those of us who persevere become despondent and we wonder whether the markets are ever going to recover and whether we should be there at all.
ADA News Bulletin October 2011
ADA News Bulletin December 2011