Anyone who is fighting a bad habit will tell you that it all started with one, seemingly tiny, mistake. That first press of the snooze button giving way to a struggle with oversleeping. The first puff of a cigarette leading to a lifetime of addiction. Innocently, and perhaps absent-mindedly, biting your nails in youth and the embarrassing consequences in adulthood. The list goes on but I think you get the point. All of these bad habits represent problems of behavior and will power that are very difficult to overcome and can present difficulties later in life.
As I said, most bad habits begin with one decision that, at the time, seems insignificant. However, in reality these “one-time only” actions end up being the spark that ignites the powder keg. This is a concept that I believe most would agree with, but do not usually think to apply to their investing. This is because most people do not think about investing as the discipline that it is. When the majority of people think about investing, they think about the end goal. They think about sitting on a beach in retirement or leaving great gobs of money to their family or favorite charity. They tend to think a lot more about the result of smart investing instead of the process that gets them there.
As a financial advisor, I have seen the impact of this way of thinking more than most. I have become thoroughly convinced that my job as an advisor is first and foremost to defend my clients against their own bad investing habits. Lest that statement be taken as condescending, let me also point out that I often run my own personal investing decisions by someone wiser and more experienced than I before clicking “Submit” on the trade order. Is this because I am incompetent or lack the discipline to take my own advice? No, or at least I certainly hope not. It is because I recognize that we as human beings have an incredible knack for getting in our own way. In our constant pursuit of happiness (and avoidance of pain), we make dizzying, often contradictory, decisions that inevitably lead to our failure to achieve that perfect picture of domestic bliss we had in our head. In investing, this can look a little something like this:
“The market is hitting all-time highs! I better invest all of my savings so that I don’t miss out!”
“The market is crashing! I had better sell my investments so that I don’t lose more money!”
“That crypto-NFT-Tesla thing is making everyone on TikTok rich! Forget a diversified portfolio, I am going all in on that!”
The result? We buy in an expensive and overpriced market, sell when it is at its trough, and then buy into the latest trend in an effort to catch back up. One small, innocuous decision leads to another until those “little decisions” become a far more dangerous habit of making all of the wrong decisions at the worst possible times. It is a vicious cycle of trying to correct past mistakes with, at best Band-Aids, and at worst crippling financial collapse. Sound dramatic? Consider what would happen if you let your bad habits get the best of you back in 2020:
Take a look at this chart and then consider a scenario where your investment returns were equal to that of the market (in this case the S&P 500 Index). In late March of 2020, the market plummeted on fears of what effect COVID-19 might have on the economy. Many pundits and talking heads proclaimed this the end of the bull market and the beginning of a recession. With the market sinking to a low of -30.43%, you could hardly be blamed for feeling that way! However, with hindsight being 20/20 (See what I did there?) we now know that the market would go on to rebound tremendously and end the year at a positive 18.40%.
The year 2020 was as perfect an example of the dangers of emotional investing, as I will likely ever see again in my lifetime. The overwhelming evidence suggests that you are far better off creating a plan and sticking to it than jumping on the latest trend on CNBC. Now, about that plan! I talk about financial planning all the time both with my clients and in these blog posts. One thing that I ought to emphasize more, especially during times of volatility such as these, is understanding your tolerance for risk. One of the biggest drivers of bad investing habits is not having a handle on how much market volatility you can mentally and emotionally endure. If a 30% drop in your account value keeps you up at night and has you frantically selling off your investments, then you are probably taking too much risk.
Everyone knows that in order to see returns in your portfolio you need to take some risk, but perhaps not all of the risk of the market. It may seem counterintuitive, but for some people accepting lower returns now may give them a better shot at reaching their financial goals than if they took on higher risk in exchange for hypothetically better returns. If slightly lower returns results in a level of volatility that you are comfortable with, that is going to give you more peace of mind than “beating the market” ever could! Not to mention that it takes the temptation to trade emotionally off the table or at least lessens it to a point that you can resist it.
So what’s the bottom line here? The key is to, “know thyself”. Know what your strengths and weaknesses are. If the ups and downs in the market don’t bother you, you can probably tolerate a more aggressive portfolio. If drops in the portfolio keep you up at night, you should probably decrease the amount of risk you are taking to a level that is manageable for you. This is a timeless lesson as we head into a new year!
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.