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Resources
Ostrich
Approach To Investing A Bird-Brained Idea
by
Chizoba Morah
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".
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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. |
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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. |
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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:
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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.
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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. |
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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. |
Disadvantages
of Passive Investing
Some disadvantages
of passive investing include the following:
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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. |
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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.
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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.
Advantages
of the Ostrich Effect
The advantages
of the ostrich effect can be both emotional and financial.
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Emotional
benefit: The psychological impact of bad news is limited
or almost nonexistent. |
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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:
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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. |
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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.
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