Buy low and sell high. Such a simple concept and one of the basic tenets of investing. Why do so many people struggle to follow this advice? Nobel Prize–winning economics professors and behavioral finance experts analyze this conundrum in great depth, but the simple explanation is that humans are psychologically wired to do the wrong thing at the wrong time when it comes to investing their hard-earned money. Behavioral finance explores the various reasons why we, as humans, find it so challenging to remain disciplined and rational about our investment decision-making. Terms such as herding, recency-bias, and loss aversion describe the cognitive obstructions humans experience when it comes to investing successfully.
Not surprisingly, investors are more comfortable when asset prices are high and considerably less comfortable when asset prices are low. Anxiety levels rise during periods of uncertainty and our ability to make rational decisions during times of stress is meaningfully impaired. The chart below is a powerful illustration of how average investors fared over the last 20 years compared to other common indexes and asset classes. This data tracks the buys, sells, and exchanges of mutual funds on a monthly basis and represents the average investor’s behavior and overall investment experience over the last two decades.
Volatility is a significant cause of anxiety for investors. The short-term swings in the market can hinder our ability to remain focused on the long-term. Rationally, we know that the market doesn’t go up every day and volatility is part of having money invested in equities, but our recency-bias and fear of losing money cause us to focus intensely on current headlines. The chart below shows just how common volatility and significant intra-year market swings have been going back to 1980. On average, the S&P 500 has had a decline from peak to trough of almost 14% each year, yet the market finished the year in positive territory about 75% of those years.
There are many ways to prevent emotional decision-making from disrupting your financial plans, but perhaps the most important is simply being aware that anxiety during turbulent market stretches is a common and natural response. Other important ways to keep emotions out of your investment decision-making include:
• Investment Policy Statement (IPS) — This document clearly lays out the purpose and overall goals of your investments. It should include asset allocation parameters, time horizon, and risk tolerance levels, and should detail how these factors fit in with your overall financial picture. This document should be periodically updated and can serve as a helpful guide for any meaningful portfolio adjustments.
• Liquidity — Ensure you have sufficient cash and/or short-term bonds to cover living expenses for at least 3–5 years. Having this cushion will provide a sense of comfort during turbulent times and also, perhaps more importantly, prevent you from having to sell high-quality stocks at depressed values to cover current expenses.
• Long-Term Outlook — Focus on timeframes well beyond the current noise of the market. This is easier said than done, but the IPS should help reinforce your discipline and serve as a reminder to be patient and resist the urge to tinker with your investments in reaction to short-term fluctuations.
• Diversification — A well-diversified portfolio with non-correlated asset classes will help provide a smoother ride. The overall allocation should be determined based on risk tolerance, required rate of return, and liquidity needs.
• Trusted Advisor — Work with an advisory team who will serve in a fiduciary capacity to provide expert investment counsel as well as emotional guidance through inevitable choppy market periods. An experienced advisor will draft the IPS, calculate the appropriate amount of liquidity for your specific needs, and construct a well-diversified portfolio that is aligned with your risk tolerance and long-term growth objectives.
* Chart 1: J.P. Morgan Asset Management; Dalbar Inc.Indexes used are as follows: REITS: NAREIT Equity REIT Index, EAFE: MSCI EAFE, Oil: WTI Index, Bonds: Bloomberg Barclays U.S. Aggregate Index, Homes: median sale price of existing single-family homes, Gold: USD/troy oz., Inflation: CPI. 60/40: A balanced portfolio with 60% invested in S&P 500 Index and 40% invested in high quality U.S. fixed income, represented by the Bloomberg Barclays U.S. Aggregate Index. The portfolio is rebalanced annually. Average asset allocation investor return is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/17 to match Dalbar’s most recent analysis. Guide to the Markets – U.S. Data are as of March 31, 2018.
** Chart 2: FactSet, Standard & Poor’s, J.P. Morgan Asset Management.Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2017, over which time period the average annual return was 8.8%. Guide to the Markets – U.S. Data are as of March 31, 2018.