|Just who is flying the plane?|
Hopefully the markets will recover further over the coming weeks. But I have tried not to get too emotional about it all - mainly by leaving the portfolio on autopilot and removing our greatest obstacle to logical decisions: our emotional reaction.
A 2005 study by three universities in the US found fascinating empirical evidence that showed that emotion is so oriented towards risk aversion that even when the benefits outweigh the losses, our brains err on the side of caution.
The study analysed the investment decisions made by people who were unable to feel emotions due to brain lesions. The subjects' IQs were normal, and the parts of their brains responsible for logic and cognitive reasoning were unaffected. Fear (of loss) seemed to play a large role in risk-avoidance behaviour of the normal participants.
This study is especially relevant because of a concept called the "equity premium puzzle" that has long puzzled financial experts: many individuals prefer to invest in bonds rather than stocks, even though stocks have historically provided a much higher rate of return.
One theory emerging from the study is that successful investors in the stock market might plausibly be called "functional psychopaths." These individuals are either much better at controlling their emotions, or perhaps don't experience emotions with the same intensity as others do. (Warren Buffett comes to mind.)
So, it might be a good idea to be aware of your emotions when investing - and to take steps to counteract your hard-wired risk-avoidance brain circuits. In other words: when the market slumps - stop, and do something else for a while.
The wonderful thing about a portfolio designed for income is that - for the most part - you can just leave it to get on with the process of generating cash. It is a completely different type of investment style compared to that of the short-term speculator, who has to be connected with writhing of the market and who needs to be able sell quickly when things go pear-shaped. By contrast, the DIY Income Investor can shut up the laptop (or switch off the desktop computer) and go for a walk in the autumn sun.
Of course, the success (or not) of the DIY Income Investor approach depends entirely on the selection of securities. If you are not going to sell out quickly at the first sign of trouble, you need to have some confidence that the shares or bonds that you buy are not suddenly going to drop in value. Needless to say, you can't always get it right - and there is always an element of risk. In fact, because I usually invest in high-yield securities (because I want as much income as is reasonable) I do push the 'risk profile' with some of my investments. My experience is that the worst doesn't usually happen - but it does happen sometimes! (Northern Rock, Lloyds, etc.)
So, the basic safeguards are:
- diversify: do rely on any one security/company for more than around 5-10% of you portfolio and don't rely overly on any particular sector of the market (like banking!)
- maintain a balance between fixed-income securities (and cash) and dividend shares
- research any new purchases with a view to medium-term sustainability: look at the business model and the causes for the current high yield (because you are buying high-yield securities, aren't you?).
- think about wider financial, economic and political trends likely to occur over the medium term and how they might impact your potential purchases
And be ready to leave the portfolio alone for a while and enjoy other things.
I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.