May 20, 2020

Financial Services: The Psychology of Investing: How We Can Be Our Own Worst Enemy

On February 12, 2020, all the major U.S. stock market indexes finished at record highs. Since then, we have witnessed an unfathomable run, with global market volatility unlike anything any of us have ever experienced. How exactly should we handle our investments in such uncertain times?

Even during times less extraordinary, we hear all of the stock market jargon: Stay the course. You won’t lose your money unless you sell. It will come back, it always does.

Despite our best efforts to convince ourselves that our money is safe, it can be difficult to contain our fears and emotions when we open up our retirement account statements, only to see our nest egg down 20 percent, 30 percent, or more.

The closer we are to retirement, the more panic we are likely to experience, especially with the prospect of having to work longer. If we are earlier in our careers, we might be tempted to sell and get out of the market since we are back to where we were three to five years ago.

The current COVID-19-induced market uncertainties notwithstanding, there have been many market corrections over the past several decades, with the Stock Market Crash of 1987, the Bust of 1999-2000, and the Great Recession of 2008. All of them have tested our fear, and our patience. All of them have revealed what is called the “psychology of investing.”

The concept is nothing new. As early as 1912, author G.C. Seldon understood that human emotions impact investment decisions, which he described in his book, “Psychology of the Stock Market.” Nowadays, there are text books devoted to the subject of how investors behave, the reasons and causes of that behavior, and why the behavior ultimately hurts their wealth.

With plenty of years of investment experience, I would like to offer some ideas that may help calm the jitters you may be feeling in the current market environment, and how you can employ reason, not emotion, in guiding your investment strategy.

DON’T: Try to Time the Market

The number one mistake investors make is trying to time the market. When the market has a correction, or sees a significant decline, many investors decide to pull the plug. In the financial business, we call this selling low. Then, when the market turns around, investors jump back in, but miss the potential gains that could have been earned. We call this buying high.

One of the greatest investors of the modern era is mutual fund manager Peter Lynch, who earned his fame while at Fidelity Investments. From 1977 to 1990, his mutual fund, the Magellan Fund, returned a tick over 29 percent annually. With one of the greatest track records over an extended period of time, Lynch became the stuff of legends on Wall Street.

With such remarkable returns, you would expect that the investors in the Magellan Fund made a fortune. Fidelity rightfully anticipated that they would have a great story to tell, so they contracted with an outside research firm to determine exactly how much the average investor in the Magellan Fund earned during Lynch’s tenure.

Let’s pause for a second to play a multiple choice game. What was the average annual return for investors in the Magellan Fund between 1977 and 1990?

A. The average Magellan Fund client performed as well as the fund overall, earning at least 29 percent annually.

B. The average Magellan Fund client performed nearly as well as the fund overall, earning between 20 and 25 percent annually.

C. The average Magellan Fund client performed moderately well, but not nearly as well as the fund overall, earning between 10 and 15 percent.

D. The average Magellan Fund client lost money during this time frame.

Because I’m asking this question, you can probably guess the right answer. Yes, the correct answer is D. The average Magellan Fund investor actually lost money during Lynch’s historic 13-year run.

How is this possible? In short, investors were participating in the fund based on their own psychology. In other words, they were selling low and buying high.

DO: Focus on Time in the Market

Had the fund investors focused on time in the market instead of timing the market, they could have realized the remarkable gains achieved by Lynch’s Magellan Fund.

Waiting for the “right time to invest” can leave investors behind, which is why retirement plans like 401(k)s and individual retirement accounts (IRAs) can be attractive investment options. A diversified retirement plan, with recurring contributions over many years and numerous market cycles, has the benefit of dollar-cost averaging.

Under a dollar-cost averaging scenario, an investor purchases Stock A for $10 per share, then the stock goes down to $5. The investor then purchases more Stock A, meaning the average cost per share is now $7.50. When Stock A returns to $7.50, the investor has now broken even, and when Stock A returns to the original $10 price per share, the investor has now earned gains.

401(k)s and IRAs often have a very handy built-in dollar-cost averaging tool called auto-rebalancing, which allocates gains into underperforming funds. When these underperforming funds come back, the investor has been accumulating shares at the lower prices.

Auto-rebalancing is an example of a rules-based approach to investing, which takes emotion out of the equation and instead relies on a dollar-cost averaging strategy, helping investors compound their dollars over an extended period of time. As the great Albert Einstein once said, “Compound interest is the eighth wonder of the world.”

Here are a few other strategies for removing the human psychology, or emotions, out of the investment process.

DON’T: Let Short-Term Events Impact Long-Term Strategy

Short-term market events, such as interest rate movement and stock market volatility, can certainly affect your psychology, but should not affect your long-term investment strategy. Don’t reallocate your portfolio based on the latest news. Don’t change your investment plan based on what you hear from the pundits on television or read about on the internet.

Here is a rule of thumb: If you hear about it on the news, it has already happened, which means the market has already reacted. You will be late to the party. This is exactly why famed investor Warren Buffet prefers to have his office located far away from the hustle of Wall Street (in Omaha, Nebraska, to be exact!).

DO: Review Your Long-Term Financial Goals

Before making any snap decisions, revisit your investment strategy to ensure that you are on track to achieving your long-term financial goals. Have a plan in place, and stick to it, regardless of the ups and downs of the financial markets. Consider setting up auto-rebalancing to assist with the management of your portfolio.

If you would like to review your investment strategy or financial goals, please contact me at [email protected] or (949) 885-2379.