Unless you’ve been living in a cave the last week, you’ve probably heard a great deal of news and opinions about the vote in Britain to leave the European Union. And even if you managed to completely avoid the news cycle, perhaps you took a peek at your investments and wondered what was going on. Clearly international events are affecting the markets, the future looks quite uncertain, and many investors are in an emotional whirlwind.
Rather than add to the pile of opinion pieces pontificating on the uncontrollable, I thought I’d take a moment to focus on what we as individual investors can learn from this situation and how these lessons can be used to improve our personal portfolio choices. I have no earthly idea how markets will react to this news over time, so let’s talk about something a little more close to home — how you react to unexpected market adversity.
It’s that time of year again when students around the country are graduating. Finishing one long journey is a combination of fear, relief, and joy, and looking forward to the one to come is part of what makes it such a special moment. It’s also a great time for personal reassessment, and the expectations an eager graduate sets today may have a measurable effect on their future success.
Watching your account balances when markets are volatile is really tough. Some people like to attribute that uneasy feeling to an undesirable excess of emotion, and believe they simply need to keep a cool head and think rationally. While that’s certainly a valid point, in my experience even the most stoic investing robot has a major blind spot when it comes to investing psychology. It’s not a character flaw, but simply human nature.
Intelligent, well-educated investors will look at a variety of investing options and make a selection at least in part based on long-term empirical measures like the average return. These smart investors are naturally wired to evaluate the world around them with their five senses and act with reason and numbers. Now these are both admirable behaviors, but there’s already a logical conflict brewing under the surface in the last two sentences that gets exposed with a wildcard many aren’t truly prepared for — uncertainty.
In my experience, when an asset allocation seems on the brink of disaster right now, the problem is most often not with your portfolio but with your perception of what an average return or a standard deviation really means. Human brains are just not naturally wired for uncertainty, and sometimes very rational people struggle with it the most.
With recent stock market turmoil, there have been plenty of renewed questions from nervous investors about the concept of investing risk. Are stocks really a good idea? Is the volatility worth it? Should I get out now while I still can?
Astute stock market bears point out that there have been many rolling periods where the inflation-adjusted stock market lost money for more than a decade. Recently, a 100% stock market investor starting in 2000 experienced 13 years of negative real returns before finally breaking even. Stocks absolutely do work out well in the long run, but if you’re not prepared to wait them out for at least a decade without questioning your plan and switching course, you may be in for a tough emotional ride. And remember, if you switch portfolios all the time you generally lose money.
Cooler heads are understandably fond of quoting the long term average returns of the stock market. Since the S&P500 averaged an 8.5% inflation-adjusted return since 1900, there are many years of history to prove that if you are patient and invest for the long run, it will all work out for the best. “High risk, high return” is a common mantra, meaning that the extra volatility carries a proportionally higher reward.
The idea that returns are linearly proportional to risk often leads to well-reasoned (but shaky, as I will explain) decisions about asset allocation. Would someone trade 1% a year for significantly more dependable returns? Judging by the popularity of hedge funds with expenses in that range that seems like a reasonable assumption, and retirees looking for consistency over maximum growth might find that particularly appealing. Would they trade 2-3% a year? Maybe not. That’s a lot of money to give up over time. So people study the averages and make the best decision they can.
But what if I told you that the risk adjusted return for stocks is a lot less than you might think?
Based on the tidal wave of new traffic, there’s a very good chance that you’re reading this thanks at least in part to the tremendous review that Portfolio Charts received today from The Reformed Broker.
The article was completely unsolicited and blew me away, and after speaking with Josh I can vouch for the fact that he is a truly helpful and insightful guy. If you’re one of the few not reading his blog already, start today!
Beyond his eye for new tools, I particularly appreciate his thoughtful perspective on investor emotion that is far too uncommon among investment advisers today.
Talking about the feel of a portfolio is important because the end investor is a human being – an emotional person who’s got to live with an asset allocation, not just cooly glance at the results, dispassionately from afar. No one is immune to the fear and greed that makes living with an asset allocation – even a good one – so difficult to do.
Read the whole thing. He nailed it.
The idea of evaluating a portfolio not only for one’s financial needs but also for their emotional needs is prescient. If all investors and advisers had such a mindset up-front, they’d likely be a lot happier and wealthier in the long run.
To all the new visitors here, welcome! Take a look around, and feel free to contact me if you have any questions.