Prudence in Both Bad Times, and Good
Prudence in Both Bad Times, and Good
Don’t be an emotional investor. Overall portfolio performance is impacted by many things: how much is invested in stocks vs bonds vs cash; are the portfolio holdings high quality and durable or volatile and risky. One of the biggest impacts on long term portfolio performance is investor behavior. Investor behavior often has a lot to do with a person’s individual appetite for risk: their risk tolerance. Risk tolerance describes how nervous or upset investors become during periods of market declines and surges. When investors become emotional, they may overreact during both bad times and good, often leading to decisions that can cause lasting damage. Let’s consider.
Emotional Lows and Highs
Since 2009, markets have been on an upward trend, called a structural bull market. Along the way, we’ve seen many ups and downs, some small and some much larger. These smaller moves along the long-term trend are called volatility, or cyclical volatility within a structural trend. Persevering through cyclical ups and downs can be nerve-wracking for investors.
Market Lows: When stocks are falling, investors prone to anxiety may start out okay, but their patience can be limited. When declines persist for several weeks into months, vulnerability and fear may begin to erode the ability to trust the overall system. An investor may begin to lose faith in the stock market, optimism about the future, the durability of the American economy, even the skill and judgment of their financial advisors and other professionals. While these feelings can be normal, successful investors know not to overreact. But crises in the markets can lead to outright fear. And fear can be a powerful, sometimes negative, motivator.
Market Highs: You might think that market highs are a time when everyone is happy. Portfolios are growing and investors can sit back and let the good times roll while they move on to other aspects of their lives. This is not always what happens. Where fear is the enemy of good decision making in downturns, greed is fear’s insidious cousin that shows up when times are good. Greed can show up in different ways but I often see it as impatience and fear of missing out or FOMO. Impatient investors want their performance to be higher; they wish they were making more, faster. An investor experiencing FOMO might see some investment they don’t own but wish they did: they might pick the hottest stock from the past six months and wish they had a chunk of money in that one. Greed-based investing can lead to problems like concentration risk or a reduced appreciation for downside protection.
Emotional-Based Investing
Emotional investing can be disruptive to long-term growth because it is based in short-term thinking. Emotional investors are trying to solve their perceived current problem, right now. In market downturns, an investor might see their account go down, week after week, and they can only take it for so long. If they decide to just “get out until things get better” they are liable to be selling at the worst time possible. And once out, they have no real idea when to get back in. The fact is that usually, historically, if they did nothing and just stayed the course and left their portfolio intact, they would recover and go on to higher highs. Many investors know they shouldn’t sell low, but they might forget this lesson when they become fearful.
On the other hand, I don’t think most investors fully recognize that they can also make costly mistakes when times are good. If impatience and FOMO take hold, investors are tempted to “chase the market” and try to buy into the things that were very hot, very recently. They may achieve some of the ongoing momentum from a particular trend. But they also may begin to concentrate too much of their investments into the market’s hottest sectors. This concentration may produce very good returns while momentum persists. But when momentum shifts and the hot sector falls out of favor, the whole portfolio might be taken down with it. We saw a painful example of this in 2022 when the tech-heavy NASDAQ fell some 33% while more balanced portfolios fell less than half of that.
Are You Comfortable with Volatility? Really?
Having a true understanding of your own risk tolerance can be very difficult. I’ve encountered investors who say they are comfortable with risk (i.e., volatility), only to find that they struggle with fear when markets fall and with impatience when markets surge. I’ve had investors tell me that all they want is to have protection on the downside, but also make big returns when markets are good. Well… unfortunately you can’t have it both ways.
We are all susceptible to the emotions of fear and greed. Many investors have an understanding that they shouldn’t invest with emotion. Emotions are normal, and investors need to learn how to understand them. It is human nature to want to just do something when it looks like things aren’t going your way. But tinkering or disrupting a game plan, especially during times of high volatility, rarely works out well.
Have a Plan. Follow the Plan.
Instead of chasing returns or trying to trade out of losses, investors are well advised to make plans around what they can in fact control. The plan can be simple:
- Asset Allocation: What percent will be invested in stocks, bonds, cash, other?
- Investment Selection: Use high quality, dependable investments (funds, ETFs, individual securities) that you can hold for long periods of time.
- Investor Behavior: As discussed in this essay, don’t let emotions override your game plan. Review the plan and its components periodically but stick to the plan.
Conclusion – The past twelve months as case study
To recap, successful investors look to the long term and know not to follow their emotions during times of high market volatility. Volatility refers to the many market highs and lows along the long-term trend. Emotions can lead to bad decisions during both lows and highs in the markets. The past twelve months provide a great case study illustrating these points. The market declines from early August through late October seemed particularly upsetting to nervous investors. I had several conversations about fearfulness that weren’t fully justified by the conditions. And now in recent weeks growth which began with big tech firms has spread across many sectors in what has become a quite broad-based bull market. Let’s not overreact to all the good news. Let’s keep our eye on the future.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Stock investing involves risk including loss of principal. Asset allocation does not ensure a profit or protect against a loss.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The data included is developed from sources believed to be providing accurate information.