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11 February 2011
As we approach the two year anniversary of the market lows reached on March 6, 2009, headlines continue to pop-up across the country “celebrating” the fact that the Dow is back over 12,000 or the S&P 500 is back to 1,300. The next column over asks, “Is it finally safe to get back into stocks?” Sadly, these headlines and questions continue to repeat themselves after every market downturn, and the herd is beginning to follow.
Until recently, investors had been consistently pulling money out of stocks and investing in bonds or cash. While the broad market has nearly doubled from its lows reached in March 2009, net mutual fund flows from US stock funds has been overwhelmingly negative. Over the past 6-8 weeks, however, investors have shown signs that they are beginning to tiptoe their way back in. Jason Zweig, a prominent Wall Street Journal journalist and author of Your Money and Your Brain, discusses this in a short video on MartketWatch.com.
The overwhelming problem with this phenomenon is that it indisputably underlines the importance of managing your behavior and demonstrating good habits in investing. The image to the right, courtesy of Carl Richards at www.behaviorgap.com, demonstrates that we feel good and bad about investing at precisely the wrong times, leading to decisions that are detrimental to our financial well-being.
To reiterate the points made above, consider this, only now, after the market has nearly doubled, are investors beginning to consider buying stocks again. In virtually any other situation in life, one would be considered crazy for behaving in such a manner. Think about it - investors are literally stating that they would rather buy the exact same item for twice as much as they sold it for! Mr. Zweig points out that the flow back into stocks at this point is merely a trickle. Unfortunately, the floodgates will really start to open if and when the market continues higher!
My last post outlined that financial products are not broken, however, the behavioral use of them produces subpar results. It is almost a given that more investors will continue to wait until prices reach higher levels. Once they reach a high enough level, they will invest their money again. And once the market does not produce their expected surge necessary to get their portfolio back to the pre-crisis levels, they will probably continue to blame Wall Street and financial products. Sadly, that surge they needed already happened and those “broken products” already provided it.
Warren Buffett’s two rules for investing are (1) Don’t lose money, and (2) never forget rule #1. Don’t get me wrong, Buffett’s portfolio goes up and down like the rest of ours. However, it is critical that you, as an investor, do not shoot yourself in the foot by making decisions that will permanently impair your life. As the evidence outlined above points out, many investors have done exactly that over the past 2 years. They have created permanent, irreversible financial losses by reacting to fear. We all know intuitively that we are supposed to buy low and sell high, but our emotional composition as human beings leads us to shut down our intuition at precisely the wrong times.
Now is not the time to get carried away in a desperate attempt to make up for what has happened. Hope is not a good investment strategy. No matter what your investment approach has been over the last few years, it is time to start over with a clear picture and a clear mind. What has happened in the past has happened and you must do whatever it takes to wipe that memory from your mind. You can only look forward from here.
As you proceed forward, always remember that price matters. As Buffett says, “price is what you pay, value is what you get.” When the stock market rises, it simply means that prices of stocks have gone up and therefore, the ultimate value you can possibly derive from those stocks has mathematically decreased (and vice versa). Neither event means that stocks have morphed into something different, the only thing that has fundamentally changed is the price. When academics and professionals alike recommend rebalancing your portfolio, it is merely taking from the outperformers (whose price has appreciated, but value has declined) and buying more of the underperformers (whose price may have declined, but value has increased).
The chart to the left is similar in nature to the previous sketch, but outlines the counter-intuitive nature of markets in a slightly different manner (it looks more complicated than it is). The “risk premium” outlined in this graph ultimately reflects value. You invest because you expect to receive a “premium” in exchange for the risk of investing in the stock market. However, the point of greatest value (when you are paid the highest premium) is when things look and feel the worst.
Ultimately, the style of investing (indexing, value investing, tactical asset allocation) you employ moving forward matters far less than allowing yourself to react emotionally to what is happening. Ignore the past, determine your overall strategy, and stay disciplined and dedicated to it. Determining a plan well in advance of future events will greatly decrease the odds of making emotional decisions in the future.
This article was originally published on the Financial Planning Association’s All Things Financial Planning Blog.
