The Psychology of Investing- Keeping Calm Amid Market Turbulence
Keys to Investment Success
Investing is not about being smart. For instance, Isaac Newton is considered one of the most important scientists in history. Even Albert Einstein said that Isaac Newton was the smartest person that ever lived. Newton developed the theory of gravity, the laws of motion, new math and calculus, and made breakthroughs in developing the modern telescope. But, in 1720, Sir Isaac Newton lost a fortune in the South Sea Company, the hottest stock in England. Newton concluded that he, "can calculate the motions of the heavenly bodies, but not the madness of people".
When it comes to investing, it is important to try our best to separate our emotions from our decision making, as hard as that may be. When external factors around us are rough, it can enhance the fear of loss that we naturally have with our investments internally. All of the media we are constantly bombarded with now does not help and is typically even the cause of that feeling. Warren Buffett once said, "We don't have to be smarter than the rest. We have to be more disciplined than the rest".
Investing and the psychology behind it is a discipline that can be built. By understanding the psychological factors of behavioral finance, we can better understand why investors often make buy/sell decisions that contradict investment best practices and rational investing.
Envy is that emotion that gets us thinking, "What if?" It is also known as FOMO, the fear of missing out. The fact that most people regret what could have been, can be very damaging if that starts to take over their emotions, affecting their thoughts about their investment plan.
Rational people would regret only bad final outcomes, but most people regret what could have been. For example, a study looked at Olympic medal winners and found that bronze medal winners were happier than silver medal winners. Why? A silver medalist likely thinks about how close he was to reaching gold. A bronze medalist, though, might imagine how close she was to not receive any medal. The happiness level of each bronze and silver winner was calculated on a scale from 1 to 10. The bronze winners had a result of 7.1 while the silver winners had a result of 4.8.
During bull markets, many investors regret their investment choices when they look at their portfolio vs. U.S. stocks. This is called S&P Envy. It is easy to see how this S&P Envy comes about. It is the inability for investors to connect the dots of investment returns over various market cycles. When the market is doing well, investors in diversified portfolios may complain that their portfolio did not make as much as the S&P 500. When the market is not doing well and returns are negative, investors in diversified portfolios may complain that their portfolio lost money. However, from 2000 to the end of 2020, the total return of the S&P 500 was 268.7% while the return of the diversified portfolio (40% U.S. stocks, 10% international stocks, 5% small cap stocks, 5% emerging market stocks, 30% U.S. bonds, 10% high yield bonds) was 275.3%. Diversification can work even when it feels like it is losing.
Lottery Ticket Effect
Another example of envy is the lottery effect. Most people will tell you that buying a lottery ticket is a poor plan for financial success. But why are we willing to play even when we know the odds are not in our favor? We are often willing to accept a high probability of poor returns for a small chance of earning large returns. This is also why investors are willing to concentrate positions in a single stock. There is a temptation to invest all in the "next great company" or find the hot investment trend.
We run serious risks when we get caught up in the lottery ticket effect. If you succumbed to S&P Envy and started "stock picking" individual stocks, there was a roughly 1 in 3 chance for each stock you picked to have lost money from 2016 to 2020. Whereas if you invested in a basket of securities like a mutual fund or ETF, only 0.2% of those funds lost money over the same 5-year period.
And as it turns out, limiting losses (especially big losses) is the true key to investing success. Warren Buffet has said that the first rule of investing is not to lose money, and that rule #2 is to not forget rule #1. It is all about math. If you start with $1 and lose half (50%), you are left with $0.50. What do you have to be up the next year to breakeven? You need to double it or be up 100% to get back to breaking even.
If you are not suffering from envy, that is wonderful, and you are probably constantly trying to minimize your losses. But on the other side of the spectrum, people will do irrational things to avoid losing things. This is where we run into loss. The overwhelming fear of losing your money can be just as harmful as not fearing it enough. Sometimes, it can even feel worse. All of us have a natural tendency to take action and try and fix our problems. We want to take control, rather than do nothing. But taking action in these times is not always the best solution.
Time in the Market vs. Timing the Market
Taking action or trying to fix your investment portfolio often leads investors to trying to time the market. If you made a hypothetical investment of $100,000 in the S&P Index from 2001 to 2020, missing just 5 of the best performing days over the last 20 years could have cost your portfolio more than $100,000- nearly a third of its potential value. If you were unfortunate enough to miss the 25 best days, you would have less money than you started with.
Waiting for the "Right Time to Invest" Can Leave You Behind
On the other side of this, when people get fearful with their investments, they tend to pull out of markets completely, fleeing to cash. These "sideline sitters" might say, "I don't want to make any changes right now, my stocks have done so well", or "With the markets hitting new highs, I have missed it and will wait for a better time". But there is no "best time" to invest (unless you are a future teller).
It may seem counterintuitive, but it can be helpful sometimes to take a contrarian approach. As Warren Buffet famously put it, "Be fearful when others are greedy. Be greedy when others are fearful". This was especially true before and after the financial crisis. Investors lost as they rode the highs of the market in 2007 and pulled out of markets during the depths of the crisis and in uncertainty.
So, it is easy to lose ourselves in our emotions. If we go one way and get too aggressive and risk-taking, we can really harm ourselves. At the same time, it is just as easy and just as harmful to be too conservative. That just leaves a very narrow, disciplined middle-ground for us to navigate. So, let's explore why it is so important to be disciplined, and what we can do to get there.
Talk to a Financial Professional
Experts typically suggest that when you are trying to break a bad habit, it is extremely helpful to tell someone else so that they hold you accountable. They can keep you disciplined and on schedule when you may feel like deviating. When it comes to investing, the perfect person for that job is a financial professional.
Working with an advisor can help to make the emotional rollercoaster ride of the markets smoother and less volatile internally. That is the power of preparation at work. Talk to us about creating an "Investment Strategy Plan", a plan that will help dictate your investment strategy, regardless of external forces. That way, when your emotions start to influence you, there are guidelines that can be followed.
As we mentioned, no one can predict what will happen next in the markets, not even expert analysts on Wall Street or TV. In a survey, only 43% correctly predicted whether interest rates would go up or down, less than the chance of getting heads from a coin flip. We cannot control the future, only ourselves and how prepared we are to face it.
So, to recap,
- Proper investor behavior is critical to investment success.
- Recognize these common mistakes and the tendency to repeat them.
- Common investor biases are a challenge (for everyone).
- Be willing to be critical even when times are good, and opportunistic when times are bad.
- Invest for the long-term.
- Don't try to time the market.
- Work with your financial professional to keep you in check, build discipline, and ensure you are reacting to the market rationally.
In the end, how we behave has a huge impact on how our portfolios behave, and often times the more we try to step in, the worse we can make it. Work to mitigate the impact your emotions have on your investments, so that you can save them for when they really matter, with the people that mean the most to you. And if recent events have reminded us of anything, it is how truly important our friends and family members are.
Click on the link below to check out the entire PowerPoint presentation from BlackRock.