July 6, 2016
The Biggest Mistake Investors Make and How to Avoid It
Please read important disclosures HERE.
July 6, 2016
Please read important disclosures HERE.
The U.S. stock market has been relatively stable over the past couple of years, following major price swings during and after the financial crisis. These recent trends fit within the market’s longer-term pattern of oscillating back-and-forth between periods of stability and periods of turmoil. Excesses build during periods of stability and the seeds are sewn for the next market crisis. When turbulence returns, prices swing dramatically until a new equilibrium is established. It follows that this current period of stability will not last; at some point, we will again have to deal with a turbulent market characterized by major price swings. Regrettably, neither we nor anyone else can reliably predict when this next round of turbulence will occur.
Turbulent markets pose a serious threat to investor portfolios since they heighten the risk of committing the biggest mistake in investing, chasing returns. This article reviews the impact of chasing returns and discusses steps you can take to mitigate this risk in your portfolio.
Chasing returns (buying stocks after they’ve already gone up and selling them after they’ve already gone down) can dramatically harm an investor’s long-term returns. DALBAR, an investment research firm, recently updated a study that estimates the actual returns earned by mutual fund investors. For the twenty years from 1995 – 2014, they found that individual investors earned just 2.5% per year, on average. By comparison, the major U.S. and foreign stock indices earned between 5% and 10% per year and the major bond indices earned between 4 and 6% annually.
What explains the terrible performance of individual investors? The largest contributor was the tendency for investors to chase returns. For example, in the late 1990s, many investors piled into tech stocks after the gains had already been made, only to suffer big losses when the bubble burst. During the financial crisis, some investors sold all of their stocks after the market had already dropped by more than 50%. The accompanying graph illustrates the evolution of emotions over a market cycle. As optimism gives way to elation, more investors pile into stocks at ever higher prices. Then, as stock prices swoon, fear takes over and investors sell at lower prices and the cycle begins anew.
You might think you are a better investor than most and therefore at little risk of chasing returns. Research in the fields of psychology and behavioral finance suggests your confidence may be misplaced. All of us are hardwired with innate cognitive biases that can make us susceptible to chasing returns. For example, hindsight bias (the tendency to believe we knew all along an event was going to happen) can lead us to be overconfident in our prediction of what the stock market will do next. Even Sir Isaac Newton wasn’t immune from the temptation of chasing returns. Newton lost a fortune from the bursting of the bubble in South Sea Company shares in 1720. He famously said, “I can calculate the movement of the stars but not the madness of men.”
The best time to equip yourself to navigate turbulent markets is when markets are relatively calm. You can accomplish this by focusing on two primary areas.
When developing your investment strategy, it is essential that you consider the impact of turbulent markets on your portfolio’s value. Your goal should be to identify an allocation to stocks and bonds that provides opportunities for growth but also seeks to limit the expected loss from a big market selloff to a level you can tolerate. Your B|O|S team plays a key role here – we work carefully with you on the front end and on an ongoing basis to develop a portfolio strategy for you that considers downside risk within the context of your goals, risk tolerance, and unique circumstances.
You can also prepare by brushing up on your understanding of the markets. This can facilitate clearer thinking during times of turmoil. For example, it can be helpful to recognize that stocks represent ownership in real businesses providing real products and services. Stock prices are not just blips on a computer screen and the stock market is not just a big casino. As long as you own a well-diversified portfolio of stocks, you should expect the majority of the companies in your portfolio to survive tough economic times and prosper when the turmoil subsides. By the same token, when the stock market is soaring, you should recognize that the profits of the companies in your portfolio are unlikely to keep pace with continued rapid market gains. During periods of exuberance, stock prices tend to grow faster than company profits, leading to higher and higher valuations and a greater risk of a big market selloff.
When severe market turbulence inevitably returns, endeavor to remain as dispassionate as possible. The following three steps can help:
First, focus on maintaining a long-term perspective. Remind yourself that you have prepared for the current turbulence. In all likelihood, you do not plan on spending most of your assets in the near-term. By tapping the stable portion of your portfolio to meet current spending needs, you can avoid selling the assets that have recently declined.
Second, minimize your exposure to the day-to-day developments in the market. Media outlets such as CNBC know that sensationalizing the news increases viewership. Don’t fall for this trap. There’s no need to check your account values hourly or even daily – once a month or even once a quarter should be more than sufficient in most instances.
Third, ignore anyone who suggests they know which way the market will go next. Inevitably, the media will trot out “experts” whose message is, “This is just the beginning. It will get a lot worse…” Nobody, neither the experts on TV, nor Warren Buffett, nor anyone else, can reliably predict how the stock market will do in the near-term.
Your B|O|S team is well aware of the severe impact that chasing returns can have on your finances and the specific risk that turbulent markets play in this regard. One of our most important responsibilities is to help you navigate volatile markets to help keep your financial plan on-track. We may go years between bouts of major turbulence, but when they occur, the stakes are high and our opportunity to add value is great.