Don’t let your emotions invest for you

Monday, October 19, 1987—aka Black Monday—was a fearful day for investors across the globe. The damage exceeded 20% in stock market declines by the time the exchanges closed. In the wake of such steep declines, investors too often are driven to act by their emotions. In this case, fear. Fear that the decline will continue. Fear that their hard earned savings will be sucked dry by the markets. A more recent example of this fear was invoked by the financial crisis. In both cases the markets recovered in short order. But, the market never recovers for those who sell out of it. Clearly, fear selling is a bad idea.

Fear is not the only emotion that muddles our investment decisions. Greed is just as dangerous.

The 1990s seemed too good to be true. Investors could not lose money in technology stocks. Valuations seemed to have changed and the exponential rising prices were within the new norm. People got greedy. Some went so far as to use their home equity to purchase stocks. And then, just like that, the party was over. The end of the decade saw technology stocks come crashing down. Those who got greedy and concentrated all of their holdings in technology stocks paid the price.

Anytime the sky is falling or the markets seem too good to be true, remember the mantra—be greedy when others are fearful and fearful when others are greedy.

While fear and greed top the list of emotions that can wreak havoc on your investments, there are others: angst and excessive pride, for instance.

The issue with angst is if you wait for events to happen (government shutdown, fiscal cliff, quantitative easing, etc.) or for the markets to “normalize,” you often miss the boat.

Excessive pride can sometimes drive people to buy individual stocks. It’s the classic cocktail party conversation where someone tells you they bought Microsoft stock in the 1990s or Apple stock at the turn of the century. They do not tell you about the other 10 stocks they bought that went south. By focusing on the one home run, people subconsciously convince themselves that investing in individual stocks is a wise venture. It’s not. In fact, it’s speculation, not investing. Do not let pride get in the way of making smart investment decisions.

Clearly we cannot let our emotions guide our investment decisions. Emotional investing is not successful investing.

Follow these steps to help avoid the pitfalls:

1)     Build a plan. Write it down and stick to it. If the markets turn over, do not deviate from your plan. If anything, rebalance your accounts back to their initial targets.

2)     Turn off the news and tune out the financial pundits. In the age of information, the evening news is not going to give you a leg up on investing. That is, everyone knows everything and it is all factored into the price of securities.

3)     Do not assume things are correlated when they are not. GDP is not nearly as highly correlated to stock market returns as people think. Nor, for that matter, are political events.

4)     Diversify your portfolio. Put another way, do not put all of your eggs in one basket. Remember what happened to technology stocks in the 1990s.

5)     Focus on what you can control. You can control how much you save and whether or not you succumb to your emotions. You cannot control the markets and politicians.

Here’s the exciting part: if you can keep your emotions at bay, invest wisely and let the markets work, you can reduce your stress and increase the likelihood of a successful retirement period.

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Maintain a long-term perspective

The last several weeks have been trying times for investors.

Since July 22nd, the S&P 500 has fallen sharply including large drops on August 8th and 10th. The main catalysts for this sharp decline include a U.S. debt deal that did not address the underlying fundamental issues in a satisfactory way, some weak U.S. economic numbers which may presage a double‐dip recession, the realization that there is little flexibility with regard to either fiscal or monetary stimulus, the S&P downgrade of U.S. debt, and the continuing debt problems in Europe.

There is a long list of troubles, and things may get worse before they get better. There are also many positives, including the following:

  • A 28% decline in the price of oil from its recent high, which has reduced inflationary pressure and helped consumers.
  • The four‐week average of initial unemployment claims declined to the lowest level since April.
  • Continuing low interest rates, on both the short and long end.
  • Greatly improved corporate profitability and cash flow, with increasing capital spending.
  • Healthy corporate balance sheets and improving consumer balance sheets.
  • A depreciating dollar which could enhance exports.

We think that the best course for long‐term investors is not to sell now. While it may be emotionally difficult, we believe it is best to stick with the asset allocation that you (and possibly your financial advisor) calmly chose which was appropriate for your circumstances and risk tolerance.

Stock prices incorporate all available public information, are forward looking and exhibit both risk and return. Selling after a sharp and sudden market decline means suffering through the market’s risk without being able to benefit from any subsequent return.

For example, there was a double‐dip recession in 1980 – 1982, with unemployment reaching a high of 10.8% while mortgage rates went above 18%. Six months after the end of the second dip, the stock market was up almost 20%.

We can’t call the market bottom with any certainty. What we do know with certainty is that institutions, investors and markets react to events. Congress may finally become serious after the S&P downgrade and work together to credibly tackle the long‐term deficit issue. Investors may look at cash‐rich companies with good earnings and lower‐than‐average valuations and eventually decide to buy. The European Central Bank has started large purchases of Italian and Spanish bonds, helping to lower rates and trying to calm the debt markets.

We certainly empathize with any distress you may have experienced due to the recent market drop. It is human nature to panic and consider selling after a steep market decline. If you are considering that, think about those portfolios which were sold at the bottom of the market in March 2009 and did not get the benefit of the subsequent recovery. Stocks have an expected positive return over time, which just became more positive with the steep price drop.

For your own benefit, avoid short‐term panic and maintain a long‐term perspective.

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Is rampant inflation an upcoming problem for the US?

I am a buy and hold investor, but two recent lectures by Niall Ferguson, a Harvard Economic-Historian, make a strong case for the impending economic collapse of the United States. He predicts default and/or rampant inflation and suggests re-allocating one’s portfolio to a mixture of gold and foreign investments. I can already hear you saying “no, this time won’t be different, America will recover”, but I suppose I just wanted to hear it straight from the source. Any words of wisdom would be most appreciated.

At any given time, it is not difficult to find somebody professing to know the short term future of the economy or the capital markets.  Quite often these people are highly regarded professionals armed with plenty of data to support their claims.  And quite often they are wrong.  History is replete with examples of how investors made wholesale changes in their portfolios based on excessively optimistic or pessimistic predictions, only to regret it deeply after the opposite occurred.

We believe that the future is fundamentally unknowable, and thus cannot be predicted with any precision. We believe investors could use their time and energy and brainpower much more effectively by controlling what they can control instead of trying to predict what cannot be predicted. We do this for our clients and with our clients by maintaining portfolios that are designed to address a wide range of economic and market climates, including inflation.

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MarketWatch: Why investors shouldn’t break with muni bonds

MarketWatch recently published an article providing some prudent perspective for those investors considering abandoning their muni bond investments. Read the full article here.

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Fear and your financial future

In this article, Paul Merriman addresses some of the fear-based questions that arise for many investors during tumultuous economic periods.

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