Many people choose to invest in shares because they understand the sharemarket, over the long term, can perform better than other asset classes (cash, fixed interest and property). Investing in shares however, without a clearly articulated objective (the why) can expose some investors to the emotional roller-coaster of share prices rising and falling. With the Australian sharemarket’s recent rise to it’s highest level in seven years, this article is a reminder about the risks of emotional investing.

Fear and greed are two emotions that drive human and investor behaviour as per the above diagram. Whether it be as individuals, or a behaviour that is exhibited by a group of people (herd mentality) we know the cycle of greed and fear which can cause emotional investors to buy or sell, is probably all too familiar a pattern and this Carl Richard’s sketch provides a powerful reminder for why you want to avoid it.

While Carl is the first to admit that he’s definitely sketched more complicated ideas, this one concept captures just how and why it’s so difficult for many people to make smart money decisions.

When you remove the emotional aspect from the process of making financial decisions – i.e. seek the advice of a qualified Financial Planner – you are better able to objectively determine whether an asset is appropriate (or not) to assist you to achieve your personal, financial and lifestyle goals. Working this out is best achieved through a discussion around goals, time frames and previous experiences, with the ultimate view to help you make the right investment choices for your situation and avoid the emotional cycle.

Why do share prices fluctuate?

It can be difficult to tell why share prices can fluctuate in the short term. Although, over the long term, the share prices of businesses listed on a stock exchange usually increase because of cautious financial management by the directors of the company.

An investor should be aware that not all company profits are distributed to investors as dividends. Part of the revenue will generally be kept by the company to reinvest into the business (for example to develop better technology, to buy other businesses, or to expand into new markets). Through these activities, it is hoped that over time the value of the company grows, and this will have a positive effect on the share price and dividends.

Similarly, if a company is performing poorly or is subject to bad financial management or loses key staff, the residual panic in the markets can lead to the sale of company shares, resulting in a decrease in the share price.

So is investing risky ?

While it is nearly impossible to predict the peaks and troughs of markets, and indeed individual share prices, most people understand there are some timing risks associated with investing, and fortunately for  investors, the two main timing risks associated with sharemarket investment can be managed:

1. Price volatility. The price of a share can fall unexpectedly and dramatically without much or any notice, however, the practice of diversification (i.e. buying shares in more than one company) can lessen this risk.

2. Variability of returns. The share market can experience fluctuating returns, which can be stressful in the short term, although history generally tells us the share market will improve its value over the medium to long term.

Depending upon your investment time horizon, and understanding when you need to access your money (i.e. a major expense or retirement) will determine whether you can afford to ignore the ‘market noise’ and ride through the short term peaks and troughs. Furthermore, if you are the sort of person that gets nervous about market fluctuations, then perhaps reducing your exposure to shares and investing in other asset classes, will assist you in getting a good night’s sleep.

Investing need not be an emotional experience when you link your investment decisions to specific short, medium and long term goals. The Adviser fp philosophy to invest in actively managed, diversified portfolios that are regularly reviewed is designed to provide a better risk/return outcome and allows investors to make an informed decision as to whether they view sharemarket volatility as a risk or an opportunity.

(sources: Lonsdale; Adviser fp; and www.behaviorgap.com)