Hindsight may be 20/20, but predicting the future is always hard. “If only I had acted.” “I knew that would happen…” “The market agreed with me at the time.” These are all thoughts that pass through most investors’ minds at one point or another. The reason investors experience such thoughts is that they are susceptible to emotional behaviors and reactions. Here are a few examples:
Fear of loss. Investors are generally motivated by fear or by greed. Behavioral scientists have learned that, for many people, the pain of loss is greater than the sense of satisfaction from a gain of the same size. Similarly, some investors will accept more risks in order to avoid a loss, but may avoid risk to seek a gain.
Taken to an extreme, fear of loss leads to investment paralysis. An excessively risk-averse investor may park funds in ultra-safe, low-yielding bank deposits or short-term Treasury securities until a decision is made, accepting long periods of low returns. Or winning investments may be sold off too quickly in an attempt to lock in gains, while losing investments manage to stay in the portfolio indefinitely.
Following the herd. It’s difficult to recognize value everyone else has overlooked. Many people find it easier to go with the crowd – to own the current hot stock or hot mutual fund.
Misery loves company, and if the investment does poorly, one has plenty of fellow sufferers with whom they can relate. However, the crowd’s investment goals may be very different from one’s own.
Hair-trigger reflexes. Markets often move in response to news. In many cases, the first market response is an overreaction, either to the up side or to the down. Sometimes “news” is only new to the general public, and has already been reflected in share prices.
The true impact of any news event can only be seen over the long-term. Generally, it’s better to wait and watch the market react to news, rather than to be a part of the reaction. Remember that market dips may present the best buying opportunities but they’re also the toughest times, emotionally, for committing to an investment.
When it comes to the financial markets, everyone wants to be in it for the up days, and out of it for the down days. “Buy low, sell high” is the advice no one can follow all of the time, or we wouldn’t have a volatile market in the first place. There’s temptation to panic and sell when a downturn occurs, but the biggest recoveries sometimes happen after the biggest down markets. Waiting too long to get back into the market risks missing that recovery, which can make a major difference in total return.
The historical record:
Business professor Javier Estrada of the IESE Business School in Barcelona, Spain, quantified the effect that exceptional days can have on investment returns. He studied the Dow Jones Industrial Average for the period from 1900 through 2006. To translate Estrada’s findings into dollars, $100 invested in the DJIA at the beginning of 1900 would have grown to $25,746 by the end of 2006. However, if the investor had missed just the ten best days of those 107 years, the investment would have grown to only $9,008–a reduction of 65%. Miss the 20 best days, and the portfolio would have grown to only $4,313. Finally, missing the 100 best days in the period under study would have resulted in a loss of capital, as the terminal wealth would have been just $83.
Of course, there are exceptional days on the downturns as well, as Estrada documents. If you had kept all the best days and avoided just the ten worst days, terminal wealth would have jumped to $78,781. If you had accurately predicted the 100 worst days and avoided them, your $100 would have grown to an astonishing $11,198,734!
And it’s not just the U.S. stock market that exhibits such behavior. Estrada went on to document similar results in foreign markets as well. He concludes: “A negligible proportion of days determines a massive creation or destruction of wealth. The odds against successful market timing are just staggering.”
Staying invested
A young investor who fears loss may want to consider dollar-cost averaging–placing the same amount into the market each month regardless of where the market is, and reducing volatility by capturing all of the market over time (including some of the downside). Over the long term, the stock market typically balances the negative and positive days. Past performance does not guarantee future results, but, overall, stocks have outperformed all other investment classes.
An older investor who needs to start portfolio withdrawals might consider adjusting the asset allocation based on a new appetite for risk, or use options to hedge investment risks. Diversification may help moderate the impact of exceptional days. On a day when the stock market overall is down, some stocks are, nevertheless, up. Stock selection matters. The bond market doesn’t always move in lockstep with the stock market, so an allocation to this asset class also may reduce the impact of daily swings. Keeping some cash on hand may help the investor weather a rough patch, or even take advantage of opportunities that arise.
The bigger question may not be which market strategy is always the best, or which stock is the best, but how does one fit all the strategies into life stages, and which is most appropriate given life circumstances at this moment? What is the best way to stay invested, while protecting purchasing power and wealth from inflation. And, how should one avoid worrying about it?
That’s where a professional client advisor, such as those at Arvest Wealth Management, can help.
A financial advisor can recognize when major life events may call for a change in risk tolerance. A financial professional is someone to turn to for recommendations on how much insurance is needed when a first baby is born, how to mitigate risk in a portfolio, or whether one has enough assets to take the next step toward a dream home or retirement. Interested in more information about how your portfolio is performing or how to stay invested despite a volatile stock market? Let us know, we’d be happy to visit with you.
This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.
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