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The Cost of Pessimism

When the economic outlook seems gloomy it can be tempting to play it safe, but you could be making an expensive mistake, warns Amy Hamilton Chadwick.

29 January 2024

Loss is painful, and when our investments perform badly, we never forget. A whole generation of Kiwi investors were scarred by the 1980s stock market crash to the extent that many never wanted to buy shares again.

“Loss aversion affects us all – regret avoidance is a strong driver of decision-making,” says Tony Alexander, independent economist. “You feel like you’re safe with the herd. It’s normal behaviour to stick with the herd, and never excel or stick out.”

We want to avoid loss, but in a diversified portfolio losses are typically temporary. Avoiding loss by not investing means missing out on significant potential gains over the long term. If you invested in the S&P 500 in 1930, and stayed invested, by 2020 your money would have grown by 17,715 per cent, according to research by the Bank of America. If, however, you missed the 10 best days each decade, your total return would have been 28 per cent.

House prices, too, have traditionally risen over time. Returns are lower than returns from shares, but the trend over the long term is for property values to increase. The average New Zealand house price in 1960 was around $6,500; it’s now over $900,000.

Waiting for the “right” moment to invest, or avoiding investing altogether, is likely to mean you miss out on returns. Over decades this may mean having less money to live on in retirement, or missing your financial targets.

“I have a close friend who, if they had taken my advice 10 years ago, would be a $1 million dollars better off by now,” says James Blair, wealth director at Lighthouse Financial. “Instead, his money has stayed in term deposits going backwards. Obviously, if you have too high a risk profile you can lose a lot of money, but if your risk profile is too low you can lose just as much.”

Even if a downturn happens, and you’re patting yourself on the back for avoiding it, you may still be worse off. One JP Morgan analyst found the average return for the two years preceding a downturn is almost 45 per cent, with a 14 per cent return for the six months before the downturn.

Waiting for the market to improve

When there is a market downturn or crash, investors’ expectations become more pessimistic despite evidence that when prices fall, your chance of strong returns increases. On average, the S&P 500 has increased 29 per cent in the three years after a decline of 20 per cent or more, dating all the way back to the 1950s.

Knowing this, Blair finds it frustrating when people tell him they’re waiting for the market to improve before they invest again.

“In 2021, at the top of the market, everybody had FOMO [fear of missing out] and they wanted to get into the market even though property and share prices were overvalued. Everybody wants to get in at the top.

“Right now there are huge opportunities for first-home buyers and long-term investors in shares, but people are scared. They’re waiting for the prices to go up, which gives them confidence – but their returns will probably be lower. We do what makes us feel safe, not what’s best for us; it’s just wired into our decision-making.”

Waiting for more information can also be a trap. “Analysis paralysis” happens when you keep researching investment options, or looking at properties, but never make a move.

“In the end you’ve got to make a decision – jump and do one thing or the other,” Alexander says. “Most people are happy with mediocrity in their lives, then they read the media and believe it when it tells them they’ve been hard done by. If you want to do better, maybe start by seeing a financial adviser.”

Can you overcome hesitation?

Talking to a financial adviser is an excellent step if you’re stuck in an anxiety loop that’s preventing you from putting your money to work. An adviser can help guide you through other steps to prevent you becoming bogged down by pessimism, such as:

Set long-term goals and make a plan to achieve them: Long-term goals help you understand your investment targets and timelines. They also allow you to model the expected returns of various investments to see whether you can realistically reach those targets. If you continue to sit out of the investment market, will you be able to enjoy the type of retirement you want?

“Opportunity cost is really important,” Blair says. “Look at the projections: what is the implication of investing in an asset, and what is the implication of not doing it?”

Put the risks into perspective: When you’re investing for decades, waiting six months or a year for the “right” time to buy into the market becomes irrelevant. Ask your parents or grandparents what they paid for their house and whether they thought it was expensive. Chances are they’ll tell you that what sounds like peanuts now felt like a big commitment at the time. Or look at the NZX 50, up nearly 500 per cent since its 2003 inception; or the S&P 500, with 130 years of reliable long-term returns.

“Waiting a few months to get into the market is completely ridiculous when you have a decades-long investment plan,” says Blair. “A good or bad bump at the start washes out over time.”

Don’t look at your investments every day: Tracking your holdings daily is probably unhelpful for your long-term strategy. Investors who check their portfolios more frequently have been shown to invest in less risky assets and have lower returns. In March 2020, more than 40,000 New Zealanders switched into lower-risk KiwiSaver funds after seeing their balances fall, but only 9.1 per cent had switched back by August. Young people were the most likely to switch and are also the most likely to be best suited to a higher-risk fund, given their long investment timeframe before retirement.

“The best clients are the ones who have lost their password,” jokes Blair. “Once you have a plan and you’ve executed it, automate it and leave it alone. Don’t get in the way of your own success.”

Try to ignore the doomsayers and keep your eyes on the horizon: The news media reports day-to-day changes in markets, but this is all noise if you are a long-term investor with a sense of perspective. If you can avoid being swayed by excess exuberance, in either direction, it will be easier to stay on track and achieve your goals.

“It’s easy to gravitate towards the dark side and feed on the negativity of others,” Alexander says. During the early stages of the pandemic, panic about housing and job markets was widespread, but Alexander kept pointing out the protective economic factors that made the worst-case scenarios less likely.

“People need reminding about the natural equilibrating forces in the economy, to drag them away from unrealistically pessimistic – or optimistic – views, and I use data and surveys to back up what I’m saying. We all need to recognise that emotions play a role in decision-making. Do your analysis and try to make your decisions more dispassionately.”

Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.


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