Everywhere you look online, you can find guides to DIY investing, this year’s investment advice, and even the best securities to add to your portfolio. The typical investor is inundated with investment advice from numerous sources, and to what end? When asked about their investment performance and returns, many DIY investors believe they are doing just fine; however, when assessed at a long-term level, many of these investors’ returns don’t even beat inflation. The average investor only yields close to 2% returns over a 20-year period. We’ll be diving into why that is and offering a step-by-step guide to improving your investment strategy.
The Pitfalls Most Investors Face
Let’s take a look at the typical investor. Between saving for retirement and investing for fun, the motivations behind various investing strategies are numerous and personal. Many investors unknowingly invest according to subconscious biases, which can have a significant impact on a portfolio’s returns over time. The 3 biases we see from Houston executives most frequently are:
- Hometown Bias: overweighting in companies from your home country, rather than appropriate diversification with international securities
- Industry Bias: tending to overweight a portfolio with securities from an investor’s job sector rather than diversifying across asset classes. For example: in Houston, we see many executives in the energy industry who have portfolios with a large percentage of their holdings in oil and energy alternatives.
- Feedback Bias: Investing should be looked at through a long-term lens, so why do so many people look at daily returns to inform their decision-making? Research has found that people who review their accounts less frequently are less likely to overreact and more comfortable with taking reasonable amounts of risk. The lower levels of scrutiny on short-term performance can be beneficial because it gives you the chance to benefit from the market’s generally good long-term returns without stressing over or reacting to short-term volatility.
For many investors, these biases can leak into an investment strategy and expose a portfolio to unnecessary additional risks.
A recent report by Dalbar found that the number one finding for an investor’s underperformance isn’t the fees or transaction costs of investing, but rather the individual’s psychology. Dalbar goes even further to define and characterize the traits that lead to underperformance.
We’ve organized them into the following three categories:
- Herding: Following what everyone else is doing in hopes it leads to "buy high/sell low."
- Media Response: The media has a bias toward optimism to sell products from advertisers and attract/view readership.
- Loss Aversion: The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as "panic selling."
- Regret: Not performing a necessary action due to the regret of a previous failure.
- Optimism: Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
Lack of Objectivity:
- Anchoring: The process of remaining focused on what happened previously and not adapting to a changing market.
- Mental Accounting: Separating performance of investments mentally to justify success and failure.
- Lack of Diversification: Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
- Narrow Framing: Making decisions about one part of the portfolio without considering the effects of the total.
While we see these psychological phenomena pretty often, I want to draw your attention specifically to loss aversion. Noted economist, Richard Thaler, did a study analyzing how investors felt after gaining or losing $100. As it turns out, people are much more affected by losing $100 than they are by gaining $100; in fact, they feel the pain of a loss 2.5x more acutely than the thrill of a win. When your emotions are riding that rollercoaster, it can be easy to pull back out of fear and make an emotional decision to avoid risk.
While many of these biases and psychological traits seem obvious and avoidable, the truth is – we see them all the time. At the end of 2018, we had numerous clients come to us saying, “the markets are declining, I need to sell and get out now.” The ones who ignored our recommendations to stay in the market missed out on the S&P 500’s 30% run-up the very next year. If the traits are so obvious, why do we see their impact so frequently?
How Much Do You Need to Get From Your Investments?
Many investors have a magic number they’re working towards getting from their investments — for return expectations, for what they need as readily available cash, and what they’ll eventually need for retirement.
We often hear mainstream media quoting historical equity market returns between 8-12% over the last 30 years. Typically, this is the “magic number” investors assume to be a reasonable expectation for their investments in the future. The reality is that the real return is often substantially less when you take out the inflation, expenses and the tax costs associated with your investments.
On the other hand, we also see investors trying to protect their returns in volatile markets by attempting to time the market and go to cash before a drop. We typically try to avoid this for two main reasons:
- Making the right timing decision twice is extremely difficult. You have to time the right time to get out, but it’s equally important and difficult timing the right time to get back in.
- While it may feel more comfortable to hold onto cash during market volatility, inflation can have a massive impact on the purchasing power of a portfolio in the long-term. Holding too much cash could impact your portfolio’s ability to keep up with inflation.
When choosing the right asset allocation for your portfolio, it’s important to assess your risk tolerance in addition to assessing what you’ll need from your investments long-term. Some of our clients want to get really conservative as they begin to age and transition into retirement because they’ve heard that they should have more fixed income in their portfolio as they age; however, equities are one of the best ways to combat inflation, so it’s important to discuss your income needs and investment strategy with a financial advisor to determine the best asset allocation for your situation.
How will the current market impact your investment withdrawals?
We often see investors looking at retirement much like a runner looks at a finish line; however, this can cloud their judgment of assessing their sequence-of-return risk and whether or not they’re financially prepared to retire. Sequence-of-returns risk simply reflects the order in which withdrawals and investment returns occur. For example, someone whose returns are 5% year-over-year looking to have a 4.5% withdrawal rate would be said to have a high sequence-of-returns risk as their returns may not cover the entirety of their retirement expenses.
Oftentimes, assessing the market’s current trajectory can make a world of difference in a portfolio’s longevity — take for instance, if you begin making investment withdrawals in a bear market where the market isn’t recouping your withdrawals in returns. It can absolutely devastate the longevity of a portfolio. Alternatively, starting off retirement with a bull market can pay off handsomely.
Sequence-of-return risk can often be compounded by retirees' psychological reactions to the market in early retirement. Quite often, we notice that retirees watch the market with greater scrutiny in their first few years outside of the office and are much more likely to react to market volatility. Now that they are living entirely off of their savings, their gut instinct will often be to “protect” their portfolio when the market is fluctuating by selling equities and going to cash exactly when they should be doing the opposite.
Why don’t most investors match the market’s long-term returns?
There’s one underlying fundamental truth we’ve covered in this article so far — the typical investor is reactive. Whether it’s a news headline or an individual security’s performance, investors tend to make one or two bad decisions with their investments every few years. What all of these decisions turn into is poor asset allocation and timing decisions — the "emotional gap."
These decisions oftentimes seem harmless at the time, like feeling uncomfortable about the market’s volatility and deciding to go to cash to wait it out. Take for instance the investors who got out of the market in 2011 following the 2008 recession — many saw the market run up from the bottom and decided to move to a more conservative asset allocation (cash, bonds, etc.) than they would have chosen anytime before the recession. While this gave some much needed assurance, what it didn’t give investors was growth. From the market’s bottom in March 2009 to 2018, the S&P 500 ran up nearly 300%, and these investors missed out because of their fear-driven asset allocation choices.
It’s your financial advisor’s job to remain objective and to assist you in making prudent decisions based on complete information instead of gut-checks or the most recent news headlines.
How to Mitigate Impulsive Reactions to Market Activity
Look at the Long-Term
One of the key ways to lessen the gut-reactions to volatility is maintaining a long-term perspective and historical understanding of the markets. Over time, there are peaks, valleys, and a combination of both in between. Understanding how to take advantage of the dips and protect your portfolio over the long-term can make all the difference in your investment strategy.
Consider Buying During a Downturn
When markets take a dip, many investors’ first thought is to “sell, sell, sell.” I have heard people say that the time to buy is only when “things settle down” or when the “news turns positive,” but let me share a secret: By the time the world appears calmer, the market has already gone up. As the saying goes, “the time to buy is when there’s blood in the streets,” or as Warren Buffet says, “be fearful when others are greedy and greedy when others are fearful.” We believe that only focusing on recent market results is a short-sighted approach, which is why we work with our clients to fine tune their long-term plan accounting for market volatility.
Target Band Rebalancing
A systemic way to buy when the market dips and sell when the market runs up is to have a rebalancing methodology. We typically advocate for target band rebalancing over calendar rebalancing, but any rebalancing is better than no rebalancing.
Target Band Rebalancing: Trades are placed to rebalance the portfolio as soon as the portfolio gets far enough away from its target allocation, or outside the predetermined “target bands” you’ve set as a target allocation
Calendar Rebalancing: Rebalancing your portfolio to your target allocations on a set schedule, for instance, once a year or every quarter
As an example, let's say you have an account with the target allocation of 65% equities and 35% fixed income.
Then, let's say the equity markets run up in a month and your initial allocation to equities grows into 72% of your total portfolio instead of the 65%. You are now overweight in equities and unintentionally taking on more risk than you prefer.
When using a target band rebalancing strategy, trades are placed to rebalance the portfolio as soon as the portfolio gets far enough away from its target allocation. To correct the above example using this strategy, you may rebalance your portfolio as soon as it hits 75% equities, which would be 10% away from the ideal allocation of the 65% equities.
If, instead, you used a calendar rebalancing strategy looking at your portfolio once a quarter, the timing of placing trades is more likely to be suboptimal. If after 3 months, your equities have run up to 72% and then fallen back to 65% (the starting allocation), because the portfolio is only reviewed at predetermined intervals, you would have missed out on the equity’s profits in the run-up.
Diversify Your Asset Allocation
It’s important to build your financial plan taking into account where you stand today and what your goals are for the future. Diversification often makes sense because it’s a form of protection.
Keeping a mix of investments in your portfolio means you’ll have the capability to bounce back faster when you encounter issues or hit unexpected bumps in the road. By balancing the appropriate liquidity for your short-term needs through cash, fixed income, or other assets alongside stocks for the long-term, your financial plan can minimize worry and emotional concerns regarding your investment options and better withstand market volatility over the years.
Rather than becoming overwrought regarding financial issues and reacting frequently to market conditions, it’s important to know how your investment pieces fit together. Understanding their connections and taking a measured approach to your investment portfolio can be key factors in successfully preparing for retirement.
At Willis Johnson and Associates, we have years of experience helping our clients take emotion out of the equation and positioning them for a successful retirement. If you need assistance with developing a long-term investment strategy, take a look at the services our team can offer.