Ostrich Approach To Investing A Bird-Brained Idea
Of the different investment strategies and behaviors that an investor or fund manager can adopt, some notable ones include active investing , passive investing and the "ostrich effect".
• Active investing involves the constant buying and selling of securities in order to profit from short-term changes in the stock market. This strategy is often very beneficial when the market is doing particularly well.
• Passive investing is just the opposite of active investing: it employs a buy-and-hold strategy to profit from long-term trends in the stock market and is used by investors who want to avoid risks.
• Both active and passive investors may exhibit the ostrich effect, or a tendency to ignore bad news in the market.
While there are similarities between passive investing and the ostrich effect, such as the risk-averse nature of the investors who practice them, there are also major differences. These differences, and the dangers of ignoring market news, will be explored here.
What Is Passive Investing?
Passive investing is a long-term strategy that involves restricted buying and selling of securities. A passive investor buys securities in order to hold them for a long period of time, because he or she believes that stocks will go up in the long run.
An investor who invests passively does not seek to beat the market; he or she just wants to match the market's returns. In order to accomplish this, passive investors often invest in index funds and exchange-traded funds (ETF) that mirror market indexes. This is why passive investing is sometimes referred to as index investing. (Get to know the most important market indexes and the pros and cons of investing in them in Index Investing.)
Advantages of Passive Investing
Some advantages of passive investing include the following:
• Lower costs and higher profits: Investing in index funds usually incurs lower management fees, because a passively traded portfolio requires fewer resources and less time to manage than an actively traded portfolio. If an actively traded portfolio yields the same returns as a passively traded portfolio, the passive investor is going to receive a higher return, because when investors sell a security, the amount of profit they receive is equal to the sell price less the buy price, minus management fees and trading commissions. (Learn how you can save on fees and commissions in Settling Wrap Fees.)
• Automatic gains from market upswings: Since passive portfolios are constructed to closely follow the performance of market benchmarks like the S&P 500, the passive investor experiences gains when the market is in an upswing. (Read more about market momentum in Divergence: The Trade Most Profitable.)
• Fewer bad management decisions: An actively traded portfolio relies on management to decide which securities to trade and when to do so, whereas a passively managed portfolio is designed to automatically track all the securities traded on a particular index. Thus, with a passively managed portfolio, there are reduced chances that the investment will be affected by bad management decisions. (Read The Cost And Consequences Of Bad Investment Advice to learn more and for more on passive portfolio management, see How Portfolio Laziness Pays Off.)
Disadvantages of Passive Investing
Some disadvantages of passive investing include the following:
• Automatic losses from market downswings: Since passive portfolios mirror the market, when the market experiences a downturn, the passive portfolio suffers, and the investor might experience losses if he or she chooses to sell during this time.
• Market outperformance: A passive investor cannot outperform the market. If an investor believes that he or she can beat the market, then passive investing is not the right strategy. (Curious about what it means to outperform the market? Learn about an investing style that aims to do just that in Defining Active Trading.)
What Is the Ostrich Effect?
The ostrich effect is a term used in behavioral finance to describe the habit of some investors to pretend that bad news in the market doesn't exist. This behavior is named after the bird because investors who behave this way "bury their heads in the sand," or ignore bad news in the market. This behavior is often displayed by investors who are risk averse. (Learn about the science behind irrational decision making and how you can avoid it in Behavioral Finance and Master Your Trading Mind Traps.)
Advantages of the Ostrich Effect
The advantages of the ostrich effect can be both emotional and financial.
• Emotional benefit: The psychological impact of bad news is limited or almost nonexistent. (Read Invest Without Stress to learn how to take the anxiety out of investing.)
• Advantages from market cycles: The market operates on a cyclical basis: it goes up and down frequently, and the only thing that is uncertain is the duration of each phase. If investors sell their securities whenever they hear bad news, there is a possibility that they might sustain unnecessary losses as well as miss out on great returns when the news turns good. Investors who ignore bad news are still in the market when returns improve, putting them in the right place at the right time.
Disadvantages of the Ostrich Effect
The ostrich effect has two disadvantages:
• Ignorance leads to major losses: If the bad news about the market is a warning that a particular investment is going bad and is unlikely to rebound, ignoring the situation can lead to major losses for the investor.
• Increased potential for missing good investment opportunities: Burying your head in the sand when it comes to bad news in the marketplace means that if there is a great investment opportunity that is contained within or is a result of the bad news, that chance is lost.
Passive Investing Versus the Ostrich Effect
It is important to know the differences between passive investing and the ostrich effect so that you are aware of the investment behavior you are engaged in and the effect it can have on your assets.
Passive investing and the ostrich effect are similar in that that investors engage in both because they are risk-averse and want to avoid losing money. However, a passive investor does not ignore news about the market, good or bad. A passive investor is willing to trade potentially higher returns for the relative safety of going along with the market.
On the other hand, an investor who exhibits the ostrich effect ignores bad news about the market and pretends that it does not exist. The ostrich effect is not an investment strategy and is not limited to just one investing style. An investor who behaves like an ostrich when there is bad news about the market can be either an active or a passive investor.
Regardless of the investment strategy you choose to adopt, being knowledgeable about events in the market, both good and bad, can mean the difference between a gain and loss. Choosing to invest in market securities and then deciding not to pay attention to the market on a bad day is a surefire way to lose money.
Conclusion
As an investor, it is very important that you be aware of news from the market and how it might affect your investments . Ignoring any news, especially bad news, can lead to poor investment decision making and major losses.
