Home Brokerage Overcoming Fear in Investing

Overcoming Fear in Investing

by internationalbanker

By Bob Homan, Chief Investment Officer, ING






Fear of the next recession, index investing and sustainable investing

What are the most important factors that determine the performance of your portfolio, and how do you deal with them? The performance of investment portfolios is driven by many factors: the economy, earnings performance, bond yields, valuations—but in the short-term, certainly, also by emotions. In my opinion, the most important emotion that plays a role in investment is fear. Fear when investing is certainly also realistic: after all, you could lose money. In addition to this primary fear, many participants in the market are also afraid of performing worse than or not as well as others. Professional investors are certainly expected to outperform the benchmark and, therefore, must perform above average. This can be pretty difficult when you know that the investment market is dominated by other professionals who are trying to do the same thing, and when ultimately, the outperformance of one is the underperformance of another.

Trends are driven by fear.

The other side of fear is greed—which is actually pretty similar to fear but the fear of missing something— and it explains a major part of price movements. There’s a reason why prices fluctuate much more strongly than the economy or the underlying corporate earnings. Not only price movements but also trends in investing can be explained by fear, in my opinion.

Fear is often a poor counsellor. If a lot of people are overly afraid of something, opportunities may arise—opportunities that are reflected in returns for investors. On the theme of fear, I would like to discuss the fear of a recession and the developments surrounding index investing and sustainable investing. To start with the former: since the Second World War, the world economy has been in recession about 15 percent of the time and in expansion about 85 percent of the time. It sometimes seems as if investors in those latter, mostly good times are mainly concerned about when the next recession will occur and how severe it will be.

In theory, the fear of recession is not surprising. But it is only when the economy shrinks that equity prices fall sharply. Since the Second World War, prices have fallen by an average of 22 percent during such periods, measured from their peaks (six months before the start of the recession, for example) to their low points—less than a year after the start of the recession. In 2008, the price drop was more than 50 percent.

Countering fear” is more rewarding.

Fear of recession leads to many investors pulling out at the wrong time—namely, when the news is bad, the fear is great, and the prices are low. They also often take the plunge again at the wrong time—i.e., when the world looks friendly, there is no fear, and prices are high. That brings me to my favourite chart for short-term price developments, in which sentiment is compared to stock-market developments a month later. You see a nice sine/cosine. If the sentiment is good, the return in the following month will be weak. But especially when the sentiment is bad, you see a very nice subsequent month on the market.

The first chart shows how the very low sentiment at the end of 2018 led to a 12.4-percent price rise at the end of the following month. This also applies the other way around—when the sentiment is very good, as it was at the beginning of 2018, a disappointing period often follows. Does it always go well when the sentiment is low? No. In approximately one in ten cases, a recession actually occurs, and prices fall further. On balance, however, “countering fear” yields more than “corroborating with fear”. The trick is to determine when and where to invest.

Investor as provider of capital is overlooked.

I come to the next development, which is partly driven by fear. This is choosing in what to invest once you have overcome the fear of starting to invest. More and more, investors are opting for passive or index investing. Investing in indices by means of ETFs (exchange-traded funds) or index funds has really taken off. I think it’s a pity that by investing in indices, the function of investors as providers of capital is overlooked. When you invest in an index, you have no connection with the underlying companies. There will be companies in the relevant indices that you like but probably also companies that you’ve never heard of or that you even regard negatively. Investing, then, becomes purely a means of achieving a return, while the other side—the allocation of capital—is almost totally ignored.

One fear creates another.

This development is logical in itself. The most important return on investment comes from taking the risk premium—and that premium is also included in the index. Furthermore, the goal is to secure the risk premium in a way that doesn’t cost much. But on the other hand, investors want to do better than average (the index), and they want to choose the right companies. And here I come to fear as a driving force. Index investing has grown enormously, precisely because a large proportion of investors are unable to keep pace with the market when selecting investments. The fear is then about not keeping up with the index, market or benchmark. Especially for professional investors, this relative performance is a major risk for keeping their jobs and reputations.

This has, however, been replaced by a new fear: the fear that index investing is a bubble that will burst one day. I’m not afraid of that precisely because there is not only one index but a whole range of indices, and also, these days, an index is created for every investment theme. The risk that too much capital is invested in just a small number of equities, which consequently become far too expensive, seems to me to be limited. I do, however, see a danger in the trade of index products, which on some stock exchanges is greater than the turnover in the underlying equities. A “flash crash” such as the one we saw a few years ago, during which ETFs were sold far below their values, is certainly possible. Not trading in panic phases or setting limits on orders provides protection in this respect.

Scope for growth is “passive” in Europe.

The second chart shows that even if the United States is the leader, there is still plenty of room in Europe for further growth of passive investment. If the money flows into passive-investment instruments continue, it will remain difficult to beat the market in the times to come. If you have any doubts about your own ability to make a good selection, or about the ability of an active investment manager to beat his benchmark, it is logical to choose a passive strategy.

Is fear also driving the growth of sustainable investing?

A final trend that I would like to discuss is the rise of sustainable investing. This trend, too, seems to be motivated by fear and greed. Some have a realistic fear that we will make our planet uninhabitable for many people and that we must, therefore, embrace sustainability in all of its facets—including investment. I think many investors experience this fear. But many others dismiss the issue, thinking, “Why should I care?”

So how can we explain the enormous advance of sustainability in the investment world? Is it because of asset managers’ and banks’ fears of missing the boat—i.e., greed? Even when the motives are very diverse and not always based purely on sustainability, the end result is good because this trend causes companies to pay more attention to sustainability as it attracts providers of debt and equity capital. I expect the movement towards sustainable investing to go even further. Many investors are now of the opinion that sustainability does not have to diminish return. I agree with them and even think that sustainable investing can add more value than conventional investing in the coming years—not only because when you consider sustainability, you often buy companies with a little more quality and less risk (i.e., risks such as the claims ensuing from environmental pollution) but also because the flow of money will mainly be directed towards sustainability in the future.

If I combine the fears of recession, not beating the market and missing the boat with sustainability, I would say that a return can be achieved by investing in equities through a sustainable index.


Related Articles

Leave a Comment

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.