Between spooky Halloween decorations, the predictable election anxiety, and a touch of understandable Covid fatigue, is seems fear is on the minds of investors these days. I’ve noticed a distinct uptick in nervous takes from stressed investors worried about everything from low interest rates to high valuations. While families with enough savings and job security to weather the lockdown storm are doing pretty well in the grand scheme of things, the thing about fear is that it’s flexible.
No matter who you are or how confident you feel, I can guarantee you have a pain point tucked away that scares the living daylights out of you. Maybe it’s spiders, heights, or rejection. Or yes, financial loss that delays your retirement or destroys your life goals. Nobody is immune. And many people seem to be sharing concerns that stocks and bonds are about to fall apart and drag their life savings into the dark financial abyss.
But make no mistake — those fears are often quite legitimate! The doomsday analysts may be completely right about the prospects for different assets. Markets shift all the time, and the question is not if but when stocks and bonds give up the ghost. So knowing that the grim financial reaper may be right around the next corner, there are at least three different options for tackling the dreaded unknown.
Deny It Exists
When dealing with the prospect of serious financial risk, the first instinct of many investors is to deny that there’s any risk at all. Maybe they preemptively label it fake news and look away. Sometimes they make fun of their worried counterparts and tell them they need to toughen up and learn to take the pain. And often they furiously search for the first article or backtest that supports their desired result while completely ignoring any dissenting opinions. I’m sure you know the type.
Denial is a relatively common trait among young investors who simply lack the personal experience to know what real investing pain feels like. If that strikes a little close to home, please don’t take offense. We’ve all been there, and it just means you’re human. For example, are you proud of yourself for staying the course during the big 30% stock market drop from the initial Coronavirus wave? You should be! Have you also wondered why older investors struggle with the same stock exposure when all they had to do was be patient and wait a few months for a full recovery? Perhaps it’s because that loss (as painful as it was) is still nothing compared to watching stocks lose half of their value and stay underwater for more than a decade as it did for investors starting in 2000. How would that experience have affected your own perception of stock risk?
In cognitive science this phenomenon is sometimes called experience bias. In backtesting terms, think of it as a form of data availability bias. Basically, when your sample is too small there’s a really good chance you’ve missed some important data points that might change the conclusions. But by denying those data points even exist, you’ve kneecapped your own decision making ability through pure deflective hubris. You can do better!
Run Like Hell
On the other end of the spectrum, there are scores of paranoid investors who live in perpetual fear of the next big market drop. Some sit on their hands and hoard cash, fearful of stocks or bonds collapsing as soon as they make a purchase. Others proactively watch the financial news like a hawk in order to skillfully dodge market turmoil hurled their way. And perhaps the biggest cohort is the group of normal people who make the best decisions they can, try to stay informed, and find themselves persistently insecure after reading scary articles written by successful investors who clearly know far more than they do. It’s enough to make even the smartest people churn portfolios until the original well-considered strategy is nothing but a distant memory.
There are three big problems with running from your fear. First, you’re just never going to be able to escape it! Even if you solve one problem in the short term, that just makes room for the next one to take over. Second, actively managing investments every day just isn’t profitably sustainable even for the most talented professionals, much less for normal people with work and family responsibilities. And third, running makes you highly susceptible to influence that isn’t necessarily in your best interests. Why do you think doomsday stories are so widespread in the media? It’s almost always to sell an expensive product or service to sufficiently frightened people just like you.
Now that doesn’t mean that there’s nothing to fear, or that defensive investing services are automatically a bad idea. There’s a place for that. But running away from adversity is no way to set yourself up for long-term success.
Face Your Fears
So if scary investing situations are both real and unavoidable, what is an educated investor supposed to do? Luckily you don’t have to accept your fate and wait for defeat, as there are several good techniques for managing unpredictable market action. The trick is to open your eyes, pull your shoulders back, and face your fears. Here are a few simple steps you can take to prepare your portfolio for anything that may happen in the markets.
Size up your fear
Think about the thing that’s worrying you the most. Maybe it’s that you heard stocks are “at an all time high” and poised for a crash. Or maybe you’ve read one of the articles recently arguing that record low bond rates are ruining bond performance looking forward. Now whether those things are true is highly debatable, but for now that honestly doesn’t matter. Just assume they are true.
Would a stock crash or bond headwinds really change anything in your life? If you’re nearing retirement with a portfolio of 100% stocks and are depressed by the idea of having to work 5-10 more years than you planned, the answer may be a resounding YES. In that case, exploring other portfolio options might be prudent. But if you’re a young investor just getting started whose annual income is larger than their investment portfolio, one could argue you’re focusing on the wrong problem entirely. Spend that energy on maximizing your income and savings, and the money you’ll accumulate may far exceed even the best gains on the relatively small amount of money in your brokerage account.
So before tackling a fear, be sure to prioritize your efforts. Some threats are more serious than others.
Plan for the worst
Let’s say you’ve taken stock of your situation and believe you might be over-exposed to an asset that could do serious harm to your important life goals should markets not cooperate. The next thing I would do is seek out examples of the absolute worst times in history for that particular asset. Basically, plan for the worst. But do it with real data rather than vague fears that may be hard to quantify.
This constructive, data-driven approach is something I believe strongly in, and Portfolio Charts contains lots of tools to help with your efforts. For example, here’s a chart for the inexperienced investors mentioned earlier that shows every compound inflation-adjusted drawdown for the US stock market since 1970. Now there’s nothing stopping the future from being even worse than the past, but expecting another drawdown of 49% that lasts 13 years at least puts a reasonable stake in the ground for planning purposes. It’s definitely better than putting too much weight into your own brief investing experience, taking a wild emotional guess, or trusting an article long on fear but short on historical context.
When studying this information and planning for the worst, it’s important to flex both sides of your brain and think not only rationally but also emotionally. How would that situation affect your plans? And how would it make you feel? Focus on solutions that meet your financial and emotional needs even in the worst case scenario, and fear will completely lose its power over you.
Build a portfolio to last
When dealing with portfolio data, it’s critical to think holistically and always study the portfolio as a whole rather than obsess about individual assets. This is often a lot harder than it sounds, as articles describing financial doom almost always focus on only one asset at a time. But context matters.
It’s hard to believe without seeing it with your own eyes, so let’s study a quick example. Look at the drawdowns charts for these four individual assets — stocks, long-term bonds, gold, and cash. Study the deepest and longest drawdowns for each. Before you move on, picture in your mind what you think the chart will look like for a portfolio that contains equal parts of these four assets. What’s the worst case scenario?
Now click the bar below to see the actual result. Is that the image you expected?
Fret about the downside potential of stocks, bonds, gold, and cash in isolation and none of them may seem like wise investments at all. But in the Permanent Portfolio they work together to create one of the most dependable asset allocations on record. And importantly, there are many portfolios that work like that! The combination of asset correlations, internal firewalls, and regular rebalancing in a well-designed portfolio serves to effectively mitigate the very real risk involved with each individual asset. Don’t let fear of the ingredients scare you away from an excellent recipe.
Embrace the idea of intelligent diversification, and you’ll eventually realize that you really don’t have to live in fear. The right portfolio can manage major negative asset swings and protect your money on autopilot so that you never have to raise a finger. And with your financial plan secured, you can finally turn off the financial news that gets you all worked up and turn your attention to things that make you happy rather than fears that stress you out.
Do you fixate on every negative investing story? Are you afraid of the markets and what might happen to your portfolio? Taking charge of your asset allocation is the single most dependable thing you can do to defeat financial terror and set you on the true path to long-term financial happiness.
So don’t be afraid! Choose a well-designed portfolio and invest with confidence.
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