Buy low and sell high. When it comes to investing, that sounds easy enough, right? Then why is it so difficult? Because, when the markets act in extreme ways (both up and down), the common reaction is to do something, anything, to feel like you’re taking action. However, this is exactly when most of us tend to make emotional, short-sighted decisions that often end up hurting our long-term results.
The distress we feel from a loss is greater than the joy of a gain, studies show. Neurologically, our loss aversion – aka running from risk — relates to our natural instinct to avoid physical pain. This instinct becomes overwhelming when it’s coupled with surprise – say a 10% or even 25% drop in the S&P 500. Ouch!
The “surprise” happens because when markets are good for a long time – as they have been recently — most people tend to downplay (1) the possibility of major price drops; AND (2) the impact on their portfolios. Then, when markets do move down — day after day after day — as they inevitably sometimes do – people suddenly realize their tolerance for risk isn’t as high as they thought. Not having worked out what a 20% or 35% drop in the stock market would mean to their finances and lifestyle (something we help clients do), many end up making the worst-possible decisions in down markets: they sell at or near the bottom.
We just can’t seem to help ourselves. No matter how much education and experience we have with investing, when an economic crisis hits and our accounts lose market value, our visceral reaction is to run, even it means locking in a loss. If this has happened to you, you’re not alone – it’s human nature.
Chilling Out in Hot Markets
Destructive investor behavior isn’t limited to down markets. There are many psychological triggers that cause investors to act irrationally – even in up markets. During a prolonged bull market, for example, more investors tend to rate themselves as above-average in managing money. It’s easy to credit ourselves for good returns and ignore the contribution of the bull market itself. It’s easy to feel like an expert.
In fact, when I start to get “hot” stock tips from parking attendants and friends at parties, that’s for me an indication that we’re in a raging bull market. Bragging about 100% returns is the modern-day equivalent of bagging a mastodon in caveman days. The danger is that if we’re overconfident about expected returns, we tend to save less and invest less. Then if those returns don’t materialize, we end up short of our goals. This can be particularly damaging for overly confident Baby Boomers as they approach retirement and face shortfalls.
The idea that emotional investing is a major handicap isn’t new, of course. Benjamin Graham, Warren Buffett’s mentor, identified the notion years ago. In his classic book The Intelligent Investor, Graham wrote:
“We have seen much more money made and kept by ‘ordinary people’
who were temperamentally well-suited for the investment process
than by those who lacked this quality, even though they had an extensive
knowledge of finance, accounting, and stock-market lore.”
The Emotional Toll
How much do emotional decisions hurt portfolio earnings? It’s hard to say exactly, but tracking the money flows in and out of stock mutual funds indicates that the average investor earns less – in many cases, much less – than fund performance reports would suggest.
Let’s look at what happened during one of the scariest months of the 2008 financial crisis. According to the research firm DALBAR, in October 2008 the average equity investor did 7.4% worse than the S&P 500. Even if the underperformance is diluted over time, it can still add up to substantially lower returns.
Not Feeling the Heat
So how can we head off emotional investing decisions at the pass?
#1. Do the work it takes to set up a diversified portfolio that accurately reflects your risk tolerance, goals and timelines. Diversified portfolios done right (1) reduce risk to what you can realistically handle; (2) keep you invested in the long run; and (3) provide a competitive return for that level of risk. A properly diversified portfolio is “as good as it gets” for your unique situation.
#2. During extreme markets, think about where we are in the emotional investing cycle. “This time it’s different.” This is what we usually hear and think during market extremes. The implication is that the bull market will always run or the bear market will always growl. Sure, this time might actually be different. But chances are it’s not. To orient yourself, ask yourself: where are we in the emotional investing cycle? Typically, the cycle starts with hoards of people running as fast as they can from risk and abandoning investments (usually near the bottom), followed by a period of insecurity and remorse as the markets recover, and eventually a stampede back into the market when confidence (and the market) is fully restored. Not giving in to the emotional investing cycle can greatly help long-term returns.
#3. Repeat and re-enforce your previous good decisions. Even the smartest, most experienced people get caught up in the never-ending barrage of messages that reinforce fear or greed. Here at LNWM, we work closely with our clients to help them set up portfolios that realistically reign in their risk, and to then advise them through the emotional investing cycle. We have gone through many market ups and downs together and look forward to more.