It's Time To Stop Reacting, Start Anticipating
One of the most important life lessons that still sticks with me is from a halftime speech where my coach said, You are reacting out there! If you are reacting, you are already too late. You need to anticipate!
Thats a lesson that helped us that day come from behind and win, but its also a lesson that can help in many aspects of life, including with our financial plans.
Last year taught us a lot, in so many ways. It was not a banner year for the stock market, with the worst start of the year ever, beginning with a 6 percent drop in just about as many days. By mid-February the drop was more than 10 percent. Then we had a series of unexpected shock waves hit global markets, first with Brexit, and then the Trump victory. When each of these events hit, what was the common investors reaction? Pull out of stocks entirely, or lessen the stock load of their overall portfolio.
A couple of weeks back, a potential client, lets call him Tim, came to our office for advice. Tim is an interesting guy. He is a very successful engineer from Morristown, who has saved about a million and a half bucks and who is looking to retire by the end of the year. After we discussed the importance of creating a retirement system that focuses on the distribution phase of his life, I dove into Tims brokerage statements. After about 30 seconds, I looked up and asked why he has a million and a half bucks sitting in a money market fund.
Tim went on to tell me that he had been invested in equities in the first half of 2016, but when Brexit hit, he sold because he could not suffer another 2008. Tim called his broker and told him to sell it all, and he moved into cash. I asked Tim, what thread of information had led him to that decision. Tim told me that he just felt it was time to move and protect. I asked what his broker said. Tims reply, Nothing. Tim further explained that he chose to remain in cash because he felt that if Trump won, the markets would collapse.
Hmm: felt, a word not associated with a sound investment plan.
To put it simply, Tim reacted to his emotions. Tim had no relevant facts to base his decision on. Tim is that classic retail investor. Gary's Weekly Finance readers know the ones. Those who react emotionally, because there is no system in place of downside risk management.
So, heres the problem with Tims reactionhe locked in his losses. Yes, 2016 started off with a big dip, but the markets were generally up about 8 percent by the end of the year. The drop from the Brexit vote was recouped within the month, and Trumps win had the opposite effect than was expected, with stock markets hitting record highs. In fact, I explained to Tim, if he had been invested in strategies using quantitative data to make sound investment decisions to manage downside risk, that data overwhelming supported equities, even with a Trump win.
So, like Tim, most people who reacted to those 2016 geopolitical events and stock market moves, likely found themselves locking in losses, or giving up gains, that oftentimes are impossible to make up before retirement. The lesson here? You guessed it. Instead of reacting to losses, investors need to anticipate risk in their portfolio. This can be done by managing volatility.
Investopedia explains market volatility as the amount of uncertainty or risk around the size of changes in a securitys value. A higher volatility means that a securitys value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short period of time, in either direction. A lower volatility means that a securitys value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.
Generally speaking, most investors are loss averse rather than risk averse. Unfortunately, many investors arent aware of the volatility associated with their investments and when designing their portfolio, they focus almost entirely on the upside potential of an investment, and do not anticipate the downside. But as I have just explained, many investors react emotionally to that downside. This ultimately affects their overall performance, as is illustrated in the annual DALBAR study.
According to the DALBAR study, investor behavior has resulted in dramatically lower returns when compared to market indices. Over a five-year period, the average equity fund investor underperformed the S&P 500 by an average of 5.65 percent a year. Additionally, the average fixed income investor returned 0.10 percent/year versus the Barclays 3.25 percent/year return. This means the average equity investor only achieved 55.05 percent of the index return and the average fixed income investor only achieved 3.08 percent of the fixed income index return.
Folks, the ability to anticipate is something that has helped me avoid a lot of hurdles in my life, but it is also a lesson that I have used a lot in my planning philosophy. This was true on the athletic field and is true in the financial ring.
Now is the time to be proactive, and anticipating the potential for risk within an overall portfolio can help you minimize the volatility that so many retail investors react to.
Link to 2016 DALBAR Study >> http://www.qidllc.com/wp-content/uploads/2016/02/2016-Dalbar-QAIB-Report.pdf