Removing Emotions from Investment Decision-Making
Financial Times states emotion-filled decisions cost investors 3% annually. They still make money, but not nearly as much considering the average annual return of most portfolios averages 5-8%. They go farther to say emotion fueled decisions create losses of 6-7% during times of stress or economic downturn. It’s just insult to injury at that point.
There was a financial advisory group that spoke to our DNAP class during the last year. They had a slide showing average portfolio returns when managed by a professional compared to self-managing. Basically, validating their services. The professionally managed data claimed 8% annually, which is reasonable for the past decade. The self-managed data claimed a measly 2% annual return.
This advisory group attributed the shortcomings to emotions. And quite frankly, they are correct. Now the discussion becomes balancing fees and results.
Is there a way to save the 200 basis points (2%) in annual advisory fees and still keep pace with the market? I think so. Here is what I’m doing to test that theory.
Have an Investment Plan
Every surgical case needs an anesthetic plan. Usually, a few plans should one fail or something exciting happens. Personal finance and investing are no different. You need a strategy.
People hate to hear it, but to have an accurate and consistent plan, a budget is a necessity. It doesn’t need to be overwhelming. Just enough to calculate how many dollars are arriving and where those dollars are going. This article is how Mrs. TFC and I budget relatively painlessly.
After you have decided how much goes towards debt and investments each month, stick to it. Be disciplined. Adhere to your financial goal.
According to major media outlets, the current economic outlook is extremely poor. If it isn’t unemployment numbers, it’s underwhelming earnings reports. If it isn’t increasing national debt, it’s increasing consumer debt.
Economic data aside, negative headlines sell. Negative emotions are said to be 6x more impactful to the reader. Even in an economy set to hit the moon, big media will still report something negative.
Relating to Financial Times data, retail investors alter their investment plan out of fear. This is the opposite mindset needed to win with investing. Millionaires are made during recessions because they buy equities and real estate at a discount.
I’m a fan of index funds. Could the value of my S&P 500 index funds go to zero? Yes. If they do, that means 500 of the largest companies in the world just went bankrupt. Hundreds of millions (if not billions) of people will be out of work. This exact situation would have been included in R.E.M.’s 1987 hit, “It’s the End of the World as We Know It.”
The S&P 500 has successfully recovered from every significant downturn. There is always a first for everything, but investing is an odds game.
Automate All Things Good
Companies decrease spending friction to see more of our hard-earned dollars buy their goods. Why not apply this to investing? You have already created a plan and determined where your dollars need to go in order to best serve you. Rinse and repeat for best results.
Our mortgage, utilities, and credit cards all have options for automatic payments. I know Vanguard offers an ”automatic transfer” option. The financial advisors I have worked with offer a similar automated option where they would then invest the money into your pre-selected options upon payment.
If you are someone needing a boost in the right direction, take advantage of these automations.
If your investment plan is reasonably solid, almost nothing should keep you from making the money moves. Does frightening news about the economy prevent me from investing in my 401(k) or sending money to Vanguard? Not at all.
I have an emergency fund set aside so I have maximal room for investments. If something catastrophic happens, I can implement a contingency plan to divert funds to replenish the emergency fund account. Other than that, maintain course.
If your plan to pay off debt is a good one, commit to it. If your investment avenue is solid, commit to it.
Don’t Check Investments Too Often
I struggled with this during my first year self-managing my accounts. Everyone logs on hoping for a green day in the market and a rapidly growing account. Here is the reality of the market.
53% up and 47% are down.
Not much has changed in recent history with 54.9% green and 45.1% red.
Keep in mind that despite there being an almost equal number of up and down days, the market over this time returned nearly 8% annually.
Here is another chart of interest looking at the significance of daily moves. The most common market gains are expectedly 0-1% and >1% at 30.2% of days and 15.2% of days respectively.
And to the downside, we have a similar looking chart. Small changes are the norm.
The market averages returns between -1% and 1% almost 70% of the time. Lots of little movements that have added up to net gains over time. When the market falls, it really falls. Gains come slowly and more frequently.
Credit to A. Sather at einvestingforbeginners.com for the data. His article can be found at this hyperlink.
Point being, if you are a helicopter parent for your investments, emotions will get the better of you. Seeing an account loss half of the time carries weight.
Mrs. TFC and I look at our finances monthly. We calculate our expenses for the month and update account balances on a spreadsheet. No more frequently than that.
Your Plan Should Be Sustainable For A Career
It is ignorant of me to say the plan will never change. There are far too many variables to account for. And I also don’t recommend the same asset allocation over a career. Pick a good index fund and stick with it. Pick a good bond fund and stick with it.
This may be a bit trickier with venture capital and real estate. Perform due diligence on the front end to ensure the product is something desirable for at least a few years to come, not the next meme stock or investing fad.
Take equities, regardless of which way the market swings today, tomorrow, next week, or next year, I don’t plan to sell any funds. All of the index funds I currently own, I plan on holding forever. Or at least until retirement. It’s a bummer when assets are worth less this month than last month, but that’s the reality. I’m playing the long game.
As I said before, the stock market can technically go to zero. The S&P 500 has a market cap of $36T. Yep, TRILLION. The global market cap is $106T. My financial eggs may not be in many baskets, but those baskets have some deep roots.
Don’t jump in and out of the market.
There are a great number of statistics proving how timing the market is unsuccessful by pretty much everyone. If the market has a big red day, down 5%, the following trading days often recover half of that loss. Traditionally, drastic market moves in either direction are followed by a reversal.
Seeing a massive drop in the market elicits fear. That $100 index fund just dropped to $95. Maybe it had another bad week and dropped to $90, which is where you decide to sell and cut your losses. Say the fund hovers between $88-92 dollars for a couple months before rebounding to $95.
You were feeling good about cutting your losses until you acknowledge the fund is valued $5 more than when you sold at $90. Hoping this rebound is short lived, you wait to buy in. A couple of weeks later the fund reaches $98. At this point you are so frustrated because you were sure the price would drop, and you could buy in at $88 or even $85 and come out ahead.
Skip ahead 1 year and guess what happened -- The fund sits at $106, and you don’t own any of it. You decide you have waited long enough and buy back in. Sell at $90 and buy at $106 – the retail trader way.
This is speaking from experience when I tried my hand at stock trading. And yes, it went exactly like this. Usually, worse. Lesson learned.
Now I focus my investments in S&P 500 index funds and total world index funds. Both low-cost, passively managed funds of course. A great way to have exposure to equities.
Good luck with your investing and thanks for reading!
