Volatile markets often bring out the worst in investors. Some bail too soon, while others prefer to "wait it out in cash." Yet another group refuses to invest in stocks at all.
All of these investors are at risk of letting their emotions determine how they invest. They are frequently wrong, costing them gains that they could otherwise reap by doing nothing.
Thanks to the emerging field of behavioral economics, we can identify what investors consistently do wrong. How do we resist the temptation to exit the market at the first sign of trouble? The best route is through identification, education, and planning.
When you can identify what behavior is likely to occur under certain market conditions, you can take corrective (or better yet, preventive) action. Here are some antidotes to behavioral mistakes that often crop up in volatile markets:
Don't Try to Time It. Nobody can tell you with any accuracy when a bull market will begin and end. It's rarely a straight line, and any number of gremlins can trigger a downturn. But trying to time the end of a bull market often leaves investors worse off than staying fully invested.
How can that be? Most investors guess wrong when timing the market. According to FactSet Research Systems, if you were to miss the 10 best days of the stock market from 1992-2013, you'd net a 5.4% annualized return. What if you were even more cautious and missed the 40 best days because you were on the sidelines? Then your annual return would average negative 0.52% during that period. In terms of dollars, the less-cautious investor would have $318,304 over 20 years, and the more-skittish investor only about $90,000 after an initial investment of $100,000. What if you did nothing and stayed in the market the entire time? You'd have $637,807, or a nearly 9% annualized return.
Money manager C. Thomas Howard, professor emeritus at the University of Denver and author of Behavioral Portfolio Management says you need to take a long-term view of the market, preferably with a "20-year-plus horizon." Even into retirement you'll need the inflation-beating growth that stocks offer. "What happens today, next week and next year is relatively unimportant," Howard says.
Minimize Trading. As noted in the previous example, there are opportunity costs in timing the market. But you can quantify other costs as well. If you're trading in a brokerage account outside of a tax-deferred vehicle, you'll pay commissions--between $4 and $20 for each transaction. The more you trade, the more you pay.
Look at your brokerage account statements during a volatile period. Were you trading a lot? Compare your net return--after commissions and taxes--to what a stock-index fund was returning during the same time span. Did you beat the market? Keep in mind that after expenses, it's incredibly difficult to consistently outperform a standard index. The numbers don't lie.
Segregate Short-Term From Long-Term Assets. You are concerned about losing money. Most people are. But you need to separate your short-term money needs from your long-term investment goals, which should include beating inflation.
Howard recommends you adopt a "bucket strategy." For immediate needs, place money in cash investments that don't lose value, such as money-market funds. These vehicles would cover your near-term expenses, those coming due from month to month. For longer-term needs, look to stocks that build wealth over time--and simply ignore the volatility from year to year. That can help you keep your emotions--and tendencies to time the market--in check and away from your long-term portfolio. (Morningstar director of personal finance Christine Benz has written extensively about the bucket approach and its psychological benefits.)
Focus on Quality Stocks for Longer-Term Needs. Although bonds are important in diversifying risk and meeting shorter-term needs, you can also bolster your longer-term stock investments' downside protection by seeking out strong dividend-paying public companies. Find companies that are consistently raising their dividends or buy mutual funds or exchange-traded funds such as the Vanguard Dividend Appreciation Index ETF (VIG). Dividend funds and stocks are not only less volatile than non-dividend payers, they offer another potent psychological benefit: You get positive reinforcement every quarter (or through a year-end distribution) when dividend payments are made.
Take a Broader View of Risk and Return. One powerful, but difficult-to-execute, technique for keeping your emotions in check is to ignore traditional measures of volatility such as standard deviation and drawdown.
"I believe that measures of volatility are largely measures of emotion," Howard says, "and should not be used in constructing and evaluating portfolios."
Does that mean you should bury your head in the sand when it comes to the various kinds of market, company, and systemic risk? Not at all. When it's taken in the right (long-term) context, risk can lead to greater rewards.
The key to not getting blinded by short-term volatility is to have a complete understanding of how much risk you want to take, why you want to take it (including the immediate and long-term needs that must be funded by your portfolio's returns), and your time frame for investing.
For that, you will need discipline and an investment policy statement that puts everything from fund selection to diversification in writing. It should make sense to you and your spouse or partner. Review it once a year and vow not to change it unless your life circumstances change. This way, you'll have a better chance of staying true to your planned course and lesser chance of getting lost in the winds of emotion.
"Emotions are the most important determinant in investment portfolios," Howard adds. "If you don't master your emotions, you will end up with less wealth."