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Separating fear and greed from your investment decisions
Emotions are a critical component of the behavior of investors, and fear was at a fever pitch prior to, and now following, the elections . I was bombarded by calls and e-mails from nervous clients asking what we've done to protect their portfolios from a major correction that would ensue after the presidential election results were in. Their overconfidence in their prognosticating abilities of pending crisis was their weakness.
After a lifetime of counseling clients to separate their emotions — such as fear, greed and overconfidence — from their investment decisions, I'm still standing my ground. The goal in my counsel, and that of my co-workers in the firm, is to have clients understand what we have known all along: We are unable to predict the market's outcome, so don't fall into the trap where you think you can make predictions or you'll ultimately increase the probability of losing money.
It becomes a self-fulfilling prophecy whereby the most predictable outcome is that emotionally charged, irrational financial decision-making leads to more money being lost than during the temporary market declines that often occur and that have always become recoveries.
Behavioral finance is a fairly new term and area of research that surfaced when researchers realized that investors, people who make otherwise rational decisions throughout much of their life, do not make rational decisions when it comes to money. Fear, greed and overconfidence are three material factors that often weigh in — even for people who have studied finance and have a good knowledge and background in markets and economics. For this reason, markets are often flooded with sales when the stock market drops and, conversely, caught in a buying frenzy when markets rise.
It's confirmation that investors are buying high and selling low, which is contradictory to Economics 101 and something most of those participating know well.
Imagine this analogy: How does one lose weight? It's simple, you do two things — you eat less and exercise more. Any questions? No, of course not. It's not knowing how to do it that is the issue, it's the execution. In investing, we know to buy low and sell high, yet often investors allow human emotion to drive their investment decisions and overtake solid rational thinking.
It's volatility in both the markets and investors' portfolios, paired with uncertainty — as we're experiencing again — that drive fear and loss aversion. Many of my clients are high-net worth individuals with senior executive positions who understand the rules of investing — including CEOs, corporate founders and presidents. Yet, I often find myself playing the role of therapist as well as that of financial advisor.
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Over the years, I've seen that my clients have a tendency to get stuck in "flee or freeze mode," unable to make sound financial choices for themselves or their families. This is where having a good financial advisor and sounding board is key.
I spend a lot of time talking clients "off the ledge" when they'd like to move all of their money into one outperforming asset class, place a large bet on hedging strategies for a pending correction they see coming or suddenly want to get out of the market altogether and "drop anchor" for fear of pending scary dives in the markets.
The key here is that your temperament is being affected for some reason, and it's critical that you recognize it. You literally need to resign yourself to the fact that you are not going to reliably call market movements in advance, particularly their onset, magnitude and duration. There is an infinite set of possible outcomes given the sheer amount of variables.
Unfortunately, what I hear from the conversations I have with clients is that they still clearly remember the 2008 financial crisis and its impact, and they cling to that memory. From my perspective, it looks very similar to post traumatic stress disorder in numerous ways and it's affecting their temperament still today. This recent election is just bringing it back to the forefront of their minds.
At the core of the temperament issue is one thing: volatility. When markets become volatile, investment timing is lost to confusion and becomes mismatched with actual market movement.
By the time market highs are reported and investors feel as though the all clear has been signaled, the market has typically already changed position so that the investor that moves on the signal, often buys at an all-time high. The same is true when markets drop and investors move and wind up selling at the lowest price in order to remove themselves from the pain of potential further portfolio losses.
Emotional investing gets the best of many investors during periods of volatility. Their otherwise strong temperament becomes weakened. The reason is that human psychology is incompatible with modern day finance, as we tend to infuse emotion into the decision-making process. It just doesn't work well.
Between the Brexit vote in the U.K. , the presidential election in the U.S. and talk about raising interest rates, the markets of the various asset classes look like a roller coaster as of late.
When there's uncertainty, it's natural to be worried. We have to remember, though, that we've survived multiple U.S. elections, and you will have many more over your investment time horizon to deal with.
We also know that, in uncertain markets, it is still better to stay the course, grab on to the side of the kayak and ride through the whitewater of the markets' concern de jour. From there, you can have a strong temperament and execute your investment plan while not losing sight of your true ultimate goals of retirement, college planning, prudent diversification, etc.
So, at the end of the day, investors have to remember that investing isn't about President-elect Donald Trump — whether you're terrified about the future or emboldened by potential change. It's about having a solid investment plan with sound financial goals and sticking with it no matter whether markets go up or down. Keep your temperament strong and your emotions out of your investment portfolio.
— By Christopher Krell, principal with Cassaday & Co.
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