How to build an investor mentality
Financial advisors can help clients manage risk by offering long-term perspective and unemotional advice
By: GAIL JOHNSON
Date: June 04,2014
Building wealth requires more than diligently putting aside money every month. It requires a shift from a saver mindset to an investor mentality – a move that’s not easy for investors who are averse to taking risks.
If only becoming comfortable with risk were as simple as abandoning the sentiments involved.
“Probably the most-often given piece of investment advice is to take all emotion out of investing,” says Peter Drake, vice-president of retirement and economic research for Fidelity Investments Canada. “It’s a great piece of advice, but it’s not realistic. We’re all human, and we all have emotions.
“When you look back, in 2005 and 2006 and markets were up, euphoria was the order of the day,” he adds. “Then we had the market correction, and we had panic and despondency.”
Investors may be more nervous now than in past decades given that today’s global economy can be affected not only by North American events that can cause markets to drop but also by severe weather elsewhere to political unrest in far-flung nations.
The media’s focus on fear can also exacerbate uncertainty.
“When you have a lot of people inherently nervous, you have a threat called contagion,” Mr. Drake explains. “That sort of thing really tends to scare people. And it’s so much more spectacular if it’s in front of a camera. We saw a lot of the doomsday scenario during the financial crisis of 2008.”
Although it’s typical for markets to rise and fall, people tend to zero in on the downturns. To get used to risk, the first step is to learn to zoom out.
“Ideally, you’re in it for the long haul,” Mr. Drake says. “We go through this roller-coaster ride regularly. We’ve seen it time and time again with market cycles. If there’s a correction for two or three years, the expectation is that it’s normal and it will continue. It can be difficult for people to recognize things do change.”
If many people are risk-averse, that’s because they’re also loss-averse. Research in behavioural finance shows that losses are felt much more deeply than gains. According to psychologist Daniel Kahneman, who won a Nobel Prize in Economic Sciences for helping develop the “Prospect Theory,” investors feel the pain of losing one dollar about 2.5 times more intensely than the pleasure they would have felt from gaining one dollar.
Talbot Stevens, an Ontario financial educator and author of The Smart Debt Coach: Secrets of the rich to increase your wealth and security, says that good habits can help people adapt to volatility.
“At least nine times out of 10, behaviour trumps math,” Mr. Stevens says. “In personal finance we need to have a foundation of numbers and values, but at the end of day most of that really isn’t as important as how we act. If we have a priority of building wealth, we’re certainly not going to run up credit-card debt. We’re going to take intelligent risks, stick to a long-term plan, learn from experiences that don’t work out the first time, and not give up. That’s the behaviour of someone who’s going to be successful.”
Being focused on the big picture is crucial to becoming comfortable with risk.
“At Fidelity, we have a longer-term perspective,” Mr. Drake says. “People really don’t grasp the concept of risk until something goes down in their portfolio. That’s a problem because we know that markets go up and markets go down, but historically markets have gone up over the long haul.”
Having at least eight years to reach your goals can help mitigate risk, Mr. Stevens says, noting that always playing it safe doesn’t necessarily pay off.
“That may be true for the shorter term – less than five years,” Mr. Stevens explains. “But once the time horizon is 10 or 20 years or more, the opposite is actually true. If you have Guaranteed Investment Certificates [GICs], you might end up with half or a quarter what you could have with other investments. You need to look at the time horizon. If you’re sticking with today’s fixed-income GICs paying three per cent and aren’t willing to take some intelligent risk, you’re really going to struggle to build wealth.”
Shifting to an investor mentality also means building a diverse portfolio.
“Be sure you’re properly diversified in equities and not invested in only one or two stocks,” Mr. Stevens says. “While equity markets fluctuate a lot in the short term, they fluctuate very little in the long run.”
It makes sense to diversify by asset types and to have a balance of equities, fixed income, and possibly real estate, and it’s also important to diversify investments geographically.
The willingness to learn from experience is another key part of the investor mindset.
“Ask yourself: ‘What do I need to do differently to be more successful next time?’ ” Mr. Stevens says. “Don’t abandon the goal or the path, particularly if you have a viable strategy. Don’t make a long-term conclusion based on short-term data.”
Solid financial advice plays an important role in managing risk as well.
“It’s more than getting advice on what securities you should have in your portfolio,” Mr. Drake says. “It’s about understanding your risk tolerance and developing a plan for whatever you’re trying to do, such as save for retirement. It’s also having somebody who can keep an eye on you and keep you on track and provide you solid, unemotional, objective advice when things in the markets aren’t going well.”