One of this blog’s key themes is that you can get wealthy through disciplined investing in stocks and avoiding the behavioral investing traps that keep you from earning your fair share of market returns. At some point, regardless of your investment strategy and who manages your portfolio, you’ll be tempted to make a costly investment mistake.
Investing is hard. I’m not talking just about skill. Owning stocks is hard. It makes us want to do things we shouldn’t. Stock market volatility is unnerving. In the short-term, markets move in different directions at fast speeds. One day’s moves seem disconnected from the previous days, and when markets decline, it’s not just numbers on a screen. Real dollars seem lost for incomprehensible reasons, making it hard to remember that great long-term returns come from standing pat. Even market advances can be confusing, as we saw in the last bull market (R.I.P. 2009 – 2020 Bull Market & Lessons Learned).
Knowing some of the behavioral investing traps you can fall into can help you avoid them and maintain your disciplined investing in stocks.
Market Timing Temptation
We know market volatility is stressful. Beyond that, when markets decline it’s tough to stay the course because bold people act, and there’s always someone claiming that market timing is possible and scaring us that things will get worse if we don’t.
Ignore the temptation and don’t listen.
Recency bias is one of behavioral investing traps economists have identified that prevents us from making sound financial decisions. It occurs when we focus on recent events instead of the long-term. In a down market, we forget the market’s upward trend and fixate on fears that the current decline is a new market paradigm to protect against. Instead of patience and discipline, we forget that declines are a buying opportunity and not a time to sell low.
Besides being impossible to do, market timing isn’t necessary.
In the short-term, the stock market hits rough patches that can lead to serious portfolio declines. In the long-run, the stock market has historically provided strong returns. The chart below highlights this by looking at the one year range of outcomes for a stock portfolio in green, bonds in blue, and a 50/50 stock-bond mix in grey over 1 year, 5 year, 10 year, and 20 year rolling time periods. As you can see, the longer your holding period, the better your investment outcomes have been.
Sure, in their worst year stocks declined 39 percent, and the 50/50 portfolio declined 15%, but as you extend your time periods, those numbers improve. At five and ten years, the all-stock portfolio has modest losses as its worst case, and at fifteen years, the worse average annual return is +6%.
The 50/50 portfolio was positive over all all the time periods except one year.
If you’ve invested in the right asset allocation based on your time horizon, you shouldn’t need market timing to protect your investments. They’re protected already. The market provides great long-term returns. The only way to access them is through disciplined investing in stocks and holding for the long run.
That doesn’t mean there aren’t steps you can take to reduce portfolio risk. There are, but not through market timing. 3 Investment Risks You Can Conquer and Protecting Your Portfolio From a Bear Market share some ideas.
Safe to Jump In
Is now a safe time to invest is a frequently asked question of advisors. The answer is yes, IF.
If you have allocated capital correctly by first paying off bad debts, building a rainy day fund, and hiring an advisor who did some planning so you’re investing only long-term money in stocks (or you set up your own portfolio that way), then it’s safe to invest in stocks according to your plan.
Most of the time, the market is up – about three-quarters of all years’ market returns are positive.
Put the money to work. Don’t miss returns. You need to invest to make money. Keeping long-term money uninvested is a capital allocation mistake. The risk of getting in at the wrong time is small, and the harm can be quickly overcome.
Maintaining Portfolio Discipline
The following scenario happens often with a diversified portfolio. You create a strategy with different asset classes, or different types of investments within each asset class. Part of the idea is that having different sources of portfolio returns is beneficial. Those different sources provide diversification, so if one investment isn’t doing well, another one is. Smoother returns should make it easier to stick to the portfolio, and less volatility leads to better long-term results.
Consider this example. Portfolio A is $10,000 and earns the following returns –
1st year: 20%
2nd year: -10%
3rd year: 12%
4th year: -5%
5th year: 10%
At the end of year 5, the $10,000 is $12,640, and the average annual return is 5.4%
Portfolio B is $10,000 and earns a steady 4.9% per year, 0.5% less than portfolio A. This portfolio grows to $12,702 – half a percent less per year, but more money.
We can argue about me cherry-picking numbers to make a point (I did), and how realistic both return streams are (no clue), but I’m illustrating a math point and my math teachers loved telling me that you can’t argue with math.
So, you’ve set up your diversified portfolio, and what happens? Not to be obnoxious, but the diversification works. Some investments do well, and some don’t. Those that don’t do well frustrate you, so you want to dump them and add to the winners. You either ask your advisor if you should, or do it yourself if you’re managing your own money.
Winners rotate. And abandoning one poor-performing investment to chase a winner is not what you want to do. Instead of buying low and selling high, you’re doing the opposite. A poor-performing investment is cheaper than before – low. A strong-performing investment is more expensive than before – high. Why would you constantly make this swap? Patience is rewarded. Your laggards will become your winners and vice versa. Don’t miss out on smoother returns by chasing performance.
Ignoring the News
Let me be clear. This isn’t about the oft-expressed concern about whether now’s the right time to invest given bad news in the world. For me, and most advisors, the answer is always the same to that one. Disciplined investing in stocks means acknowledging the following:
- It’s impossible to anticipate how markets are going to react to any news or event.
- It’s impossible to time the markets even if you could make that anticipation.
- As long as you’re investing the right way based on your time horizon, you’ll be fine.
- Stock markets can move in the short-term based on news, but in the long run, they’re driven by the long-term performance of the underlying businesses.
Instead, this is a warning to protect yourself against something that seems like a good idea, but isn’t. It’s a warning against a market timing temptation that arrives in the sheep’s clothing of fake investment advice. I first wrote about this in Protecting Your Portfolio From The News, but it’s worth repeating.
Markets discount, and the news reports. Getting that backwards can crush your portfolio.
You own an investment—let’s say it’s an emerging markets stock fund. The fund is performing poorly, while your US stock investments are doing well. You want to dump the loser, but know you shouldn’t. So, you stick to your plan. Then you start reading. Articles in The Economist, The Wall Street Journal, and the like are talking about how bad the emerging markets are performing. They explain what’s going on in those economies that may be making their markets perform poorly. It’s all bleak and ugly stuff leading to bleak and ugly returns, including pithy quotes about how bad things are.
Aha! You knew it. You have to get out of that investment now.
Or do you? This is a news article, not investment analysis, despite the august publication it’s in. A market is performing poorly, and a respected media outlet is telling you about it and providing context since it would otherwise be a short and boring article.
I hate most weather analogies—unless they’re my own and I really need to make a point—but when the weather report tells you it’s cold and wet outside, why it’s cold and wet, and the precautions you should take to stay safe, warm, and dry, it doesn’t mean they canceled spring. It’s just what this raw winter day looks like.
Reporters aren’t investment analysts, and current events are not a way to figure out future returns.
Major jargon alert: The markets are a discounting mechanism. Markets discount, which means market participants make investment decisions now about expected future returns. The news reports what’s going on today.
That emerging market investment that’s been tanking—yes, it’s had an ugly ride, but what will it do from here? Is this an attractive price to buy it, since the future earnings you are purchasing cost less? The US stock fund that’s been on a tear—that’s been a great investment until now, what’ll happen to it next? Maybe it’s still reasonably priced and will continue to do well, or maybe that dollar of earnings you are buying is now too expensive to expect a decent return. That’s the analysis disciplined investing in stocks requires, but we too often conflate the report on current events with a future investment outlook.
Suggested Further Reading
Learning to Avoid the Sunk-Cost Effect with Bill Belichick – The New England Patriots spent more on free agency this year than they ever have and gave us a master class in avoiding the sunk-cost effect. A key lesson in avoiding behavioral investing traps.