As Published in the Summer 2014 Edition of NJ Lifestyle
WE HAVE ALL HEARD THE NUMBER ONE RULE OF INVESTING – BUY LOW, SELL HIGH. Simple in theory, yet counter intuitive to what our emotions dictate. Many times as the markets are soaring to new highs, our emotions tell us to, as Jim Cramer would say, “buy – buy – buy.” March 2009 proved to be one of the best investment opportunities with a nearly 200% gain since; however, our emotions at the market bottom begged us to sell. Keeping our emotions in check, especially fear, greed, and regret, is vitally important for the long term success of any investment portfolio.
According to the recent 2014 release of DALBAR’s Quantitative Analysis of Investor Behavior, over the 10 years ending December 31, 2013, an average investor in a blend of equities and fixed income mutual funds has earned an average annualized return of 2.6% net. This compares to a 7.4% return for the S&P 500 and a 4.6% return for fixed income. This return differential can be largely attributed to investor emotion affecting rational thinking. What can investors do to close this return gap and stop letting emotions sabotage their investment portfolios?
One of the best things an investor can do is to formulate and construct a well thought out investment plan. The investment plan should include specific goals of the investment portfolio, risk tolerance, time horizon, liquidity needs, tax and legal constraints, as well as any unique circumstances. By having an investment plan, particularly a written one, investors can refer to it during times of market uncertainty, and be better able to remain focused on their goals and reduce the chance of emotions influencing short term irrational decision making. Documenting changes is a great tool for investors to track their decisions and use their past experiences as a guide to how they are likely to respond to future market moves.
Understanding your personal risk tolerance is key to not abandoning your investment plan. Often times investors expect to keep pace with the market in good years, and not lose money in the bad years. This scenario is not realistic and educating oneself on the risk/return tradeoff will help shine a light on the realities of investing. The higher return we expect to earn is correlated with a higher degree of risk. How much are you comfortable losing in a single year? 5%? 15%? 30%? The markets will fluctuate but over time investors should be compensated for the level of risk they are willing to bear. Not understanding the downside risk of a particular return strategy will lead to investors bailing at the worst possible time – the bottom of a down market. The S&P 500 has been positive in 26 of the last 34 years; however, the average intra-year decline during that period has been 14.4%. Trying to time the market would have proven to be an impossible task and, most likely, would have led to selling after a decline, and buying back in after a recovery. Understanding your level of comfort with market volatility will allow you to create an appropriate asset allocation to buy and hold through the market cycles.
One of the easiest solutions to emotional investing is to check your investment portfolio less often. More frequent reviews lead to more worry, and ultimately, to decisions that you may regret down the road. Since 1928, stocks on a daily basis have been positive 53% of the time. Extending out to monthly, quarterly, and annually, the market is positive 62%, 68%, and 72% respectively. Think of it this way – if you check your portfolio every day, there is a 47% chance that you will feel disappointed. If you only check once a quarter, you will only feel disappointed 32% of the time!
Keeping emotions out of investing can be a difficult task. We are all human, investment professionals included, and are thus prone to the euphoria and stress of the markets. Some of the best advice we have heard is to treat a bear market the same as running into an actual bear. If you hike the woods long enough there is a high probability of confronting a bear. Experts agree that panicking and running away lessen your chance of survival, but if you keep your cool and play dead until the threat passes, you can emerge victoriously and continue on your path.
Tom Reynolds, CPA & Matt Reynolds CPA, CFP®
Co-Managing Partners – CRA Financial
Robert T. Martin, CFP®
(This article is for informational and educational purposes only and should not be relied upon as the basis for an investment decision. Consult your financial adviser, as well as your tax and/or legal advisers, regarding your personal circumstances before making investment decisions.)