Investment DecisionsFaulty Reasoning: How To Make Better Investment Decisions. Photo: Jim Makos (Flickr)

Faulty Reasoning: How To Make Better Investment Decisions

In the second of her guest articles on investments, Hannah Goldsmith of Goldsmith Financial Solutions discusses the dangers of faulty reasoning and how investors can seek to make better investment decisions...

You can read Hannah's first article below:

When Stock Prices Fall: Investors & the Cycle of Faulty Reasoning

Making Better Investment Decisions

One of the interesting psychological factors we have to contend with as investors is the very human fear of loss. It is an interesting question as to why we invest if we are so scared that we will lose our money.

The answer is simply that we know that unless we invest in something, that the value of our capital will decrease over time because of inflation. The problem we have is that it’s impossible to make good money decisions all the time.

If we invested for today’s market conditions, tomorrow it could all change. If we are out of a particular global market we may not recoup the lost growth for many years. If we then change our stocks again to capture tomorrow’s market returns, then we are just reducing our capital value due to buying / selling fees and taxes - and this is not the way to invest. Unfortunately many investors get hooked into this kind of unhelpful cycle.

What is a more productive way for investors to behave?

The global market is an effective information processing machine; there are more than 98 million trades a day. The real time information they bring to the market helps set the market price.

Instead of buying retail funds selected by a fund manager buy a diversified basket of global index tracker funds and let the markets work for you. Holding a wide basket of stocks from around the world, linked directly to market returns, can reduce the risk of trying to outguess the markets or worse, pay somebody to outguess the markets.

Investment returns are random; they cannot be predicted with any great future certainty. Therefore, no one can say, with conviction, which financial sectors an investor should buy to get the next best return on their investments.

Hannah Goldsmith

Therefore limiting one’s investment universe to a handful of stocks, or even to one stock market, is a concentrated strategy with high risk implications. Do not try and guess which parts of the world will outperform others, or whether bonds will outperform equities, or if large stocks will outperform small stocks; buy the global market using a diversified basket of index tracker funds and leave the speculation to the gamblers.

Overcome Inertia

Investors need to ensure they have a cost-effective (i.e. low fee) portfolio. This means overcoming a tendency to inertia and taking time to research and review fees regularly. It’s the hidden fees and costs which are taken from your fund in the name of service costs, annual management charges and discretionary management that are often unnecessary. Try to keep the costs of managing your portfolio under 1%. The industry average cost of using a conventional financial service company is in the region of 2.3%. If you save yourself even 1% a year you will have made a substantial amount of money using compounding interest over the life of your portfolio.

Looking at examples is a good way to drive the message home.
A) If you invested £100,000 with a traditional financial services company paying a total fee of 2.3%, and you received a 7% return on your money for 25 years, you will have a projected future value of £329,332. As £100,000 was yours to start with you will have made a £229,332 profit. The overall cost to you, to make that profit, will have been £109,912.

B) If you invested £100,000 in a low fee portfolio, paying a total fee of 1.11% and received a 7% return on your money for 25 years you will have a projected future value of £441,601. As £100,000 was yours to start with you will have made a £341,601 profit. The overall cost to you would be £63,718.

This additional £112,269 can be used by you and your family, rather than just giving it away to an industry that feeds the ‘fat cats’. Remember it’s your money … don’t give it away.

The psychological trait we need to foster is patience. Don’t jump the minute the market starts to drop. Manage your emotions by investing in a risk portfolio that is correlated to your capacity for loss. Not one that is based purely on your search for the highest returns. Remember, investing is for the longer term. History says that you will be rewarded for your bravery – and your patience.

Hannah Goldsmith is founder of Goldsmith Financial Solutions and author of Retire Faster. You can find find Hannah on Twitter @HannahGFS