In part 1 of “A Better Investment Experience”, we discussed the importance of embracing market pricing and avoiding chasing performance. In part 2 of this series, we’ll focus on managing the emotions of investing and the characteristics of a sound investment plan.
Managing the Emotions of Investing
Emotions play a major role in our investment (and life) related decision making. A downside of these emotions is that they often cause us to think and act irrationally despite whatever fact-based evidence we are shown. Finding a way to manage these emotions is key in finding a path towards a better investment experience and ultimately achieving your long-term investment goals. Emotions aren’t all bad obviously, but making big financial decisions based solely on emotions is a recipe for disaster.
In order to manage them, we need to know how these emotions manifest. Here’s a typical cycle of investing related emotions that you’ve no doubt come across in some form.
When things are good, we buy more. When things are bad, we want to sell and go to cash. Another way to put this is that our emotions can cause us to want to buy high and sell low… not the best strategy.
It’s totally unrealistic to think we can quell every investment related emotion we have, but we can minimize the chances that we’ll act on emotion alone. One way to do this is by asking yourself questions like:
“What does history tell me about the direction of market prices?”
“How does reacting to short-term events affect my long-term returns?”
Let’s take a stab at answering these questions.
First off, history has shown that markets weather every storm and continue to move higher over the long-run. We can see from the chart below that good times for the market have been disproportionately longer than the bad times and the duration of a bull market is not a reliable indicator of the duration or magnitude of the next bear market.
In reality, the consequences of missing part of the bounce can be more lasting than the bear markets themselves.
This next chart shows the distribution of yearly US market returns since 1926 stacked by range.
Over this time horizon, the market has had a positive annual return 75% of the time, with positive performance more concentrated in the higher ranges of returns. This is just another way of saying that the long-term direction of equity prices as a whole has always been up.
The second question we can ask ourselves: “How does reacting to short-term events affect my long-term returns?”
To begin to answer this question, lets take a look at how the average investor (who likely exhibits emotional biases) has done over time relative to other asset classes.
The orange bar represents the average investor’s annualized return from 1998 through 2018 (data was collected from thousands of anonymized brokerage and mutual fund accounts). The average investor, riding that emotional roller-coaster of elation and fear has done slightly better than inflation over the last 20 years (2.6% vs 2.1%). In contrast, buying and holding a 60/40 portfolio of stocks and bonds that is rebalanced annually produced a 6.4% annualized return. That 3.8% difference could certainly be the difference between meeting your financial goals and falling significantly short.
Think you can time the market and come out the other side in one piece? Not as easy as it looks, and it doesn’t take much of a slip up to impact returns. We’ve shown the below chart before, but its worth repeating.
Each bar shows the return after accounting for missing the best x number of days over the time period. Missing out on even a few of the market’s best days each year can have a significant impact on cumulative returns. So, the bottom line is yes, reacting to short-term events can adversely affect long-term outcomes.
Eliminating emotional biases is not going to happen. but being aware of them may help us think twice before we make an investment decision that lessens the likelihood of a secure financial future.
Characteristics of a Sound Investment Plan
Ok, you’re aware of your emotional biases and are sticking to your investment plan. Well, if that plan is garbage, all the emotional awareness in the world won’t ensure your long-term goals are met.
Everyone’s situation is different, and there are enough idiosyncrasies in people’s lives that it would take pages and pages to cover every random scenario. There are however some common general characteristics of sound investment/financial plans.
- Clearly articulated financial goals
- Accurate and specific accounting of assets, liabilities, income, expenses, taxes, etc.
- Plan uses quantitative and qualitative data to asses ability to take risk
- Asset allocation aligns with specific goals and risk tolerance
- Assets are diversified and managed in such a way that taxes, turnover and expenses are minimized
- Plan must remain flexible to account for big life events
- Pathways exist for open communication between the financial advisor and client, ensuring both parties are on the same page
Again, this is by no means an exhaustive list, just some common traits to keep in mind as you think about your own plan.
The ability to manage emotions is critical if we are to avoid making rash decisions that can affect our long-term financial security. Possessing a sound investment plan is equally as important. Having one of these things without the other however, is almost as bad as lacking both.
Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.