During a recent presentation to investors, I ended with a graphic from Dimensional Fund Advisors illustrating mental errors common to investors. In all likelihood you’ve probably heard (or said) some of these yourself.
- The market tanked and I should have seen it coming.
- I have a proven system for picking winning fund managers.
- I wasn’t wrong about that stock, just unlucky.
- I work in that industry, so I know where it’s going.
- The trend looks good and should continue for a long time.
- It was a bad idea, but I don’t want to sell at a loss.
- I knew this stock would go up.
- My research confirms this is a great stock to own.
Do any of those sound familiar?
There are many others. In fact, most of those market rationalizations sound overly optimistic. In reality, being overly cautious is another common mistake.
I was at a Labor Day party when the conversation turned to investments, as often happens when people get together. Several people discussed their cash positions, and why they won’t put those funds into the market.
Now, I have zero idea how much those folks actually hold in cash. Maybe it’s the perfect amount for an emergency fund or to meet comfort levels. But here’s something I saw all too often as a financial advisor: New clients would come in holding way too much cash in their brokerage accounts.
I’m talking about hundreds of thousands of dollars, much more than a year’s worth of expenses, or funds earmarked for a specific purpose, such as a new car or a home remodel.
I completely understand that news events can make investors nervous about putting more money into the market. I’m talking to you, 2021 people! Because that phenomenon didn’t start with the pandemic, or with the current political situation in the U.S. No, I’ve been seeing that kind of nervousness for over a decade. There’s always going to be some reason that it feels terrifying to take the risk of investing in stocks, fixed income or alternative assets.
The problem with that reluctance is that a portfolio overweighted in cash is unlikely to generate the return you need to achieve your financial goals. Usually, the main goal is retirement. A successful retirement outcome means your money – from all your sources of income – will last as long as you do. You don’t want to outlive your money.
While cash may feel very safe and prudent, it simply won’t stay ahead of inflation over time like stocks will.
Why Disciplined Investing is Difficult
While many investors believe they are sophisticated enough to avoid common pitfalls, nearly everyone has some kind of bias when it comes to the market. The human brain is not wired for consistently disciplined investing.
For example, many of my new clients at my financial advisory firm had no investment philosophy whatsoever.
In my experience, even seasoned investors can be swayed by a pet economic theory or a belief that a particular asset class or stock is bound to do well this year.
Those may sound like investment philosophies, but they’re just opinions. There’s no strategic program to govern your investment choices.
You Need to Have a Plan
By the way, I’m not saying you have to invest in a bunch of index funds and never trade stocks. Far from it. But all your investments and trades should be part of a predetermined plan. Perhaps your stock trades are your “fun money” where you hope for the best, but if you pick wrong, it won’t destroy your retirement.
Markets work, although it’s easy to forget that in a period of downside volatility. That’s a starting point to develop a philosophy.
Also, diversification really is important. I know how that can sound to stock traders, and I am well aware that U.S. equities have outperformed other asset classes for several years now. Nonetheless, there will come a day when other assets will yield a better return, and it’s wise to understand how to gain exposure to those within your portfolio.
Finally, risk and return are related. This comes back to the idea of measuring your risk, both to the upside and the downside. Are you retired but your portfolio consists of only domestic large-cap single stocks? Or are you (or your spouse) more comfortable with a large cash stash? As noted earlier, either of those can be a big mistake, resulting in a less-than-optimal financial outcome.
I understand that for many investors, the idea of a “high risk tolerance” seems like a badge of honor, but it’s not really. Your risk tolerance is mostly determined by your time horizon (the number of years your money has to last) and your financial goals. Are you 65 and hope to purchase a vacation home in the next couple of years, and fly your family in to visit?
That’s a very different outcome than one in which you retire in your current home, which you own outright. Your travel plans include some domestic trips and you see yourself living simply, yet comfortably.
Your investing philosophy should be, “Anything to beat the market.” That’s actually meaningless, as it has zero relationship with your own needs and goals.
Humans aren’t really wired for disciplined investing, which makes it all the more crucial to take a step back at regular intervals, and determine whether your investments are tailored to meet your own financial objectives. Without that step, you may be in for an unpleasant surprise.
Are you the rare disciplined investor? What’s your investment philosophy or plan? Tell us about it in the comments below.