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Investing Psychology (II)
Estimated reading time: 12 minutes

Key takeaways:

  • For every piece of investment wisdom out there, there will almost always be 2 sides to the coin

  • Time in the market can beat timing the market, although being able to avoid the market's worst days can improve overall returns

  • The principle of buy low, sell high normally is the way to go, but each part of this piece of wisdom ("buy low" and "sell high") sometimes may not materialise

  • Allowing good-performing assets to continue rising is good to reap the compounding effect, but it may not be ideal to hold on to these assets forever

  • Cut losses early and systematically, but note that sometimes, not all losses need to be cut per se

DISCLAIMER: The following content represents entirely my own perspectives and opinions  it does NOT constitute any form of product marketing or recommendation, nor does it represent any form of financial advice per se.  

The thought processes once you've started your investing journey

In this sequel to Investing Psychology (I), I will discuss some common thought processes and ideas which apply to when you have started your investing journey

 

Much like life is a marathon, the journey to wealth accumulation – of which investments are an integral part – is a marathon too. 

 

As such, it is important to keep your mind strong during the process too, after you've gotten over the initial hurdles and started your journey. 

 

In this article, I aim to provide a comparative discussion on 4 common perspectives among investors out there, to provide you with some food for thought on how you want to approach your own investing.  

1.  "Time in the market beats timing the market"

How is this a good idea?

 

The above phrase aptly captures the divergence between Investing and Trading: whereas investors tend to keep their money invested in the medium and long-term, traders are those who enter and exit the market on a regular basis.

Investors who believe in the "time in the market" mantra most commonly cite compound interest – the "8th wonder of the world" within some investment circles – as a key factor in wealth accumulation. 

 

Let's examine how this works, although I think some of you might already have some sort of idea.

According to a Business Insider article in May 2022, since 1957, the S&P500 stock index (one of the main stock indexes for the US) has averaged a 10.7% annual return

 

Let us now examine 3 individuals, Adam, Bertrand and Charlie, who invested in the S&P500.  

  • Assume all 3 individuals invested $10,000 initially, and did not invest any additional funds since their initial purchase

  • Adam invests for 10 years

  • Bertrand invests for 20 years

  • Charlie invests for 25 years

Let's now calculate each investor's total wealth and return, which can be done using simple compounding:

Adam: [10,000 x (1 + 10.7%) ^ 10] = $27,636 (wealth increased $17,636; ~ 276% return)

Bertrand: [10,000 x (1 + 10.7%) ^ 20] = $76,375 (wealth increased $66,375; ~ 763% return)

Charlie: [10,000 x (1 + 10.7%) ^ 25] = $126,967 (wealth increased $116,967; ~ 1270% return)

The example quite clearly illustrates the effect of compounding.  Firstly, between Adam and Bertrand, Bertrand stayed invested for twice as long as Adam.  However, Bertrand's returns are FAR MORE than twice that of Adam

 

Second, notice the differences in final wealth between the Bertrand-Charlie pair, and the Adam-Bertrand pair.  

 

Between Adam and Bertrand, a difference of $48,739 was achieved through a 10-year gap in their investment timeframes. 

 

Between Charlie and Bertrand, a $50,592 difference (larger than the Adam-Bertrand gap) was achieved, but with just 5 years of difference.  

This is the wonder of compounding: the more patient you are – the longer you stay invested in the market without withdrawing your funds – your gains become disproportionately larger over time.

 

In other words, your returns from staying invested are, on average, exponential, as shown in the plotted graph below:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Source: Self-created diagram

In fact, if you read articles about Warren Buffett, one of the wealthiest men in the world, you realize that more than 70% of his wealth was actually created just within the last 20 years or so of his life. 

 

This may also be attributed to how he has stayed in the market throughout his life, rather than, perhaps, retiring at 60, taking out all his money, and going to play golf every day.  

From yet another perspective, staying invested in the market means that you will not miss its best-performing days.  Many articles have found that your average returns take a major hit if you do not catch these best days. 

 

For instance, in this article by Hartford Funds in 2021, based on the S&P500's returns, missing the market's 10 best days would reduce an investor's overall gains by more than 50% – a loss which decreases further if the market's 30 best days in a year are missed.

Source: Fidelity

Alternative view

 

There is, however, a valid view against simply staying in the market.  This probably applies to more risk averse individuals, as well as traders

 

A key principle is that losses hurt more than gains.  A very simple example would be:

Assuming I invest $10,000 and lose 50%, I would be left with $5,000.  But to break even (that is, get my wealth back up to $10,000), I would now need a 100% gain.  Thus, a 50% loss entails double the gain in order to break even. 

 

With this in mind, according to research by the Bank of America, as cited in this 2021 article by CNBC, indeed, by avoiding the market's worst days, one can indeed significantly amplify their gains.

Source: Bank of America (2021)

Synthesis

 

In this case then, the main question to ask ourselves is: do we trust our projections on which are the best and worst days of the market?  For most people, myself included, we cannot lay claim to such confidence. 

 

For instance, in the Hartford Funds article I shared above, from 1992 to 2021, 50% of the the S&P500's 50 best days occurred during a bear market

 

Touching your heart, within a period of market carnage, would you really vouch for an outstanding market day to occur within this time frame?

 

Even if you may be a sharp news reader or signal-catching technical analyst and exit the market in time before it's collapse, can you really say that you will act equally resolutely and re-enter the market while the it still appears to be dropping

 

For most people, the answer to the above tends to be no.

My 2 cents is, therefore, that if you have a long investment horizon and significant spare capital, then locking part of it away for a long time (but within good choices of assets) might just be your ticket to faster wealth accumulation.

2.  "Buy low, sell high"

How is this a good idea?

 

Investor panic is commonly observed in stock market crashes, and it’s NOT good.  When a stock’s price starts to tank, investors panic and try to sell out (to cut their losses). 

 

This in turn drives the stock’s price EVEN lower, and investors panic more, and sell more – a vicious cycle

 

But a smarter investor like yourself, having done your homework on your stock or asset and ascertained its quality, should be able to stay calm.

 

In a market downturn, we can either (a) wait out the recession, or (b) average downwards (in other words, dollar-cost averaging) by deploying more cash to buy your chosen asset (usually at a steep discount, good for you!). 

 

In essence, price falls are NOT necessarily bad – you just need to #keepcalm and continue investing ~

Alternative View #1

 

Nonetheless, be careful, and be aware, that buying low DOESN’T automatically guarantee being able to sell high later

 

Firstly, certain stocks are beaten down for good reasons, and should legitimately NOT be touched for the foreseeable future.  These stocks are typically ones experiencing systemic or fundamental issues, which affect their long-term prospects.

 

Secondly, certain stocks simply do not have enough (or the right) prevailing news, coverage, or catalysts to perpetuate a reversal in weak or downward price momentum

 

When the market isn’t paying attention to a certain stock, and/or trading volume (aka how much of the stock is being bought and sold) is relatively low, it is very difficult for the stock to experience significant price bumps

 

If the market’s sentiments towards a certain sector are poor, then stocks in these fields will generally suffer all together (though for sure, some will be worse than others).  In essence, high tides lift all boats, but the converse is also true when for low tides.

 

To illustrate the this point, even good stocks can be continuously beaten down – consider the case of Alibaba (HKEX: 9988 / NYSE: BABA), which fell almost 70% from its most recent high due to incessant government regulation, and generally poor economic sentiment.

 

TradingView price chart of Alibaba (NYSE: BABA)

It has really just kept going down, down and down...

This was recently exacerbated by renewed lockdown in various Chinese cities, such as Shanghai – as of mid-2022 – as well as news on the potential delisting of Chinese stocks from the New York Stock Exchange.

Alternative View #2

 

At the same time, you may find, looking at certain growth or momentum stocks (whose prices have only gone up and up), you MAY need to make do with "Buy high, sell higher".  

For such stocks, the wait to enter into a position may be long and agonizing

 

Each time you say “Ahh, the stock price has already reached a historical high, let's just wait for it to come down a little”, the next minute you know, it might have gone up by another 10% (which is common on bigger exchanges in Europe, America and China).  

 

In such cases, it will not suffice to simply look at the stock’s absolute price.  Through comparisons against historical average ratios, and the relevant ratios of sector counterparts, you can get a better sense of the relative price of your stocks.

 

For instance, despite how its price has continued to get higher, you see that the your stock of interest is currently price at around 45 times of its annual earnings (otherwise known as its price-earnings or PE ratio). 

 

If its same-sector counterparts are running on PE ratios of 50, 60, or more, then that could be an indication that your stock is, in reality, fairly cheap.

Nonetheless, a big qualification to this view is that sometimes, the price momentum of a stock may not be purely because of its improving financial numbers, but also due to greed

 

The common saying in the stock market is to avoid chasing a "boat that has sailed"

 

In the case where a hyped up stock has already seen its price rise by a few multiples (5 or 6 times, for instance), buying in together with other investors may or may not be rational (think Internet or technology stocks in the dot.com bubble).

For stocks/assets without proper fundamentals, too fast a run-up in price, without proper support and resistance testing (to be covered in another article), often is followed by an equally hard fall

 

Taken to the extreme, we have stocks/assets which rocketed to the moon because of mania – e.g. DogeCoin; Shiba Inu coin.  These assets typically cannot sustain their momentum, and can experience MASSIVE price swings of > 50%, even in a day. 

 

TradingView Dogecoin/USD price chart, showing a massive 1-day price spike of > 50%

Knowing this, touch your heart and ask yourself: Is your mind ready for such volatility?

3.  "I'll just leave my winners to do their thing"

How is this a good idea?

 

Don’t unnecessarily constrain yourself: “Oh, my stock is already 10% up, I should just take profit in case”.  Selected properly, there is a reason why certain stocks become "winners" for you. 

 

You should maximize your win by letting their gains accrue – you will reap the wonderful effects of compounding.  This neatly ties in with the first point I highlighted above – that time in the market beats timing the market. 

 

Indeed, since the early days of the stock market, "multi-baggers" (stocks whose prices have risen by a large multiple) have been a known phenomenon. 

 

Today, multi-baggers are particularly common in larger markets such as China and the US, and can net you profits of, for instance, 5 or 6 times your initial investment.  

TradingView price chart of AEM (SGX: AWX), whose price rose by about 700% from 2019 to 2022 

Multi-baggers can happen in Singapore as well!

To know whether your holding is STILL a winner, remember to conduct regular checks on their fundamentals and business – DO NOT OMIT performing this step. 

 

You can do this in several different ways (which I will discuss in greater detail in my articles on Fundamental and Technical Analysis):

  • Directly using the company annual or quarterly reports (depending on how frequently you monitor the company).  

  • Third-party stock information websites (recommendation: Morningstar).  

  • Analyst reports and target prices, to get a sense of what other professionals think of the business (e.g. SG Investors IO; Xueqiu and Finance Sina for China).  

  • Technical analysis – e.g. see whether the uptrend you have graphed remains intact

Alternative view

 

But riding out your winners does NOT mean that you hold on to them FOREVER.  There are a few reasons for this.

Firstly, as hinted about 4 paragraphs above, your stock should still be a winner if you continue to hold it. 

 

This can be tricky to ascertain, especially in market downturns or bear runs, whereby it is almost inevitable that your assets' performance (and that of their underlying companies) will take a hit. 

 

What is thus important is that there should not be any systemic or fundamental flaw in the company's performance that affects its long-term prospects. 

 

Should there be such problems, you will be able to find reports about it, and see it through the financial reports (there is typically deterioration in numbers even before events such as downturns).  

Second, from the point of view of technical analysis (i.e. looking at stock price charts), a loss of consistent and strong upward price movements can be a signal to take profit. 

 

It means that the stock's run may be over, IF certain technical indicators and price levels are triggered/breached (more on this in a future article).

Third, holding the same stocks/holdings forever might not be ideal because you effectively lock up your capital, and cannot use it for things like rebalancing your portfolio. 

 

Portfolio rebalancing refers to adjusting the relative proportions of your asset holdings, for reasons such as mitigating portfolio risk, and ensuring sufficient diversification of your asset holdings (by the amount of money placed in each of them). 

By allowing 1 or 2 holdings to take up too much of your portfolio, the overall portfolio risk will increase, and may exceed what you might be able to tolerate.

4.  "I should cut my losses as early as possible"

How is this a good idea?

 

Losses are fundamentally more harder to recoup it takes a more than proportionate gain to even out any losses you sustain. 

 

To illustrate this principle, consider a stock originally priced at $100.  A 50% loss takes the price down to $50.  For the stock to return to its original price of $100, a 100% gain is subsequently required.

 

If your investment approach is playing it safe, you can set yourself a threshold regarding how much of a price dip you can allow before you sell your shares. 

 

This can be by percentage for instance, a maximum decrease 20% from your initial entry price before you sell your asset.

 

Other methods/yardsticks can also be used, such as standard deviation (e.g. the stock's price falls by 1 standard deviation from its 5-year average), or by support and resistance levels on the asset's price chart (more on this in a future article).  

Alternative view

 

However, not all losses need to be cut.  There are 2 main reasons.

Firstlyregression to the mean.  There ISN'T a single asset in the world whose price has continuously risen through its lifetime what goes up, will come down (this is called a price correction). 

 

Corrections can take different magnitudes, but can range from between 10% and 30%.  Even corrections of even 40% or 50% do occasionally happen, if the market is really bad.

Bs long as these corrections are not due to any fundamental issues with company, it MIGHT make sense to ride out heavier losses for the corresponding asset.

Second, if your asset's price falls without good reason, you can see the price decline as an opportunity to do dollar-cost-averaging, which lowers your average purchase price, and allows you to capture a greater upside once your stock recovers. 

 

Of course, again, this assumes that your chosen asset is a quality one, with good future potential.  

Conclusion

This article has provided some food for thought on investing psychology, once you've started out

 

As you probably realise, there are always 2 sides to a coin in this case, the "aphorisms" you typically hear regarding investing will definitely also have their flip side. 

 

It is up to you to feel things out for yourself, and ultimately decide which view(s) you agree with, and which you would want to adopt for yourself.

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