Avoiding Self-destructive Investor Behavior
When the next downturn hits
This article was originally written in September 2015. Between August 1st and August 25th of that year, the S&P 500 Index dropped 11.23%. International stocks dropped roughly 10% during this period and emerging markets stocks (China, Brazil, etc.) dropped almost 15%. Professional pundits will provided plenty of reasons for this sudden decline, to include the slowdown of the Chinese economy, continued issues with Greece, a decline in the price of oil, and last but not least, fear that the Federal Reserve may be raising interest rates.
Our thoughts at the time will continue to be true again and again
Before I offer my thoughts on the market and how one should react, let me start with a great quote from one of the greatest mutual fund managers of all time, Peter Lynch: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
I find this quote particularly helpful right now because it seems like everyone is wondering if the next 2008 is right around the corner. This is a perfectly normal reaction since the pain of 2008’s market crash is still fresh in everyone’s mind. So please allow me 5 minutes to provide our view of the investment world right now and how this impacts you.
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
- This type of volatility is actually quite normal. We experienced the same thing in 2014 and in 2011. On both occasions external factors were to blame, at least according to the headline news. The reality is no one knows for sure why the market does what it does in the short term. What we do know is that in the short term the stock market is driven by supply and demand, and when times get tough, novice investors get out. This causes prices to fall even further. In the long run the stock market is driven by the profits of the companies you are investing in. If you are saving for retirement or already retired, you should be a long term investor and not a short-term speculator.
- This is precisely why you should be diversified. During this same 3 week stretch, the Vanguard Balanced index (VBIAX) was down just 6.48%, about ½ of the overall stock market 1. In the short-term diversification cannot protect investors from declines, but in the long run you want to own different types of investments that do well in different environments. Ray Dalio of Bridgewater Associates (the largest U.S. hedge fund) has coined this concept “The All-Weather Portfolio”. This means owning some investments that will do well when interest rates rise; others when interest rates fall. Some that do well in a recession; others in an expansion. Diversification does not mean simply owning 10 different mutual funds. It’s what those funds are invested in that defines whether or not you are diversified. Diversification (Asset Allocation) does not guarantee a profit or protect against loss.
- Checking your investment account every day or even every week is not helpful. When you invest in a broadly diversified portfolio you are not betting on a given stock or any one sector. You are investing in the economy as a whole, and over time your money will grow as the economy grows.
- Your investment account shows the daily fluctuation in price, not value. The price of your investments changes daily, and when the prices are falling this is reflected as a loss on your account statements. However, if we are not selling (and hopefully you are not) as prices fall, you are not locking in losses. This is a very important distinction to make.
Finally, it’s quite possible that the stock market will fall further before rising again. This will not change one thing that has been written here. A big part of an Advisor’s job is to help clients avoid doing the wrong thing at the wrong time. Much has been written about what one should ask when interviewing financial advisors. My favorite question and the one I would encourage each of you to ask is, “how will you help me avoid self-destructive investor behavior?”