What I Didn’t Do On My Summer Vacation
The following blog was originally posted on Forbes.com.
The dense woods and still lakes of northern Michigan make for a wonderful late summer vacation. Making things even better, at least where my family and I spend time each year, is the nearly complete lack of Internet connectivity. With the exception of climbing a hill to a building in our campground that does in fact have Wi-Fi or driving into town, you’re in the dark. For all of us who spend most of their time fully plugged in, getting off the grid is a discomfiting but ultimately fantastic experience.
And, hey, we’ve been in the most tranquil bull market in modern history, so what could possibly go wrong in late August when many others in finance are also on the beach?
A lot, apparently. In one of the more schizophrenic weeks in market history, we witnessed both extreme volatility and a ho-hum start-to-finish return. “Volatility of volatility” jumped off the charts, but the S&P 500 Index for the week of August 24, 2015 gained a modest 0.9%. I did climb that hill to check in a few times, but for the most part my experience from last week was simply having a few more dollars in my account than when I had left.
Many others had a different experience. In scanning the data and headlines upon my return, I gather the chatter and consternation was at a fever pitch. Nor was it just words: investors immediately responded to the declines by selling: the approximate $19 billion in equity fund outflows on August 25th was the largest daily outflow since 2007. These investors then missed the fierce late week rally that would have brought them back to scratch.
Unfortunately, this emotional response to volatility is exactly why so many investors underperform their own investments – what Morningstar calls the “investor shortfall.” That is, by buying and selling at inopportune times, folks effectively buy high and sell low, which is the opposite of what we all strive to do.
So for those of us unlucky enough to not be disconnected in a forest when such events happen, what should we do? The smartest answer is: Nothing, at least until things calm down. That’s a common theme I’ve read among smart bloggers. I agree. But we also need to appreciate that doing nothing when fear sets in sounds great, but is hard to pull off. Our brains are hardwired with a fight-or-flight instinct; staying calm doesn’t feel natural.
In response, here are my thoughts on specific actions we can take that prepare us best for times like last week.
1) Have a plan. Yes, this is the “eat healthy food” piece of advice that we all know is the right path, but many still choose not to follow. A recent global survey of individual investors found that 67% of respondents did not have a financial plan and 77% made investment decisions based on “gut” feeling.
My view is that individuals and advisors who are buying and selling securities outside of the context of a well-defined plan – one which clearly delineates specific goals, time frames, and risk tolerances – are basically gambling. True, there are better and worse ways to play the odds and plenty of bets win. “More” is not a financial plan, yet that is what many investors want from their portfolios, both now and later.
At the very least, the plan serves as a reference point for any decisions that could be made under duress. For stock investors, inevitable bouts of volatility are an opportunity to review the plan, but rarely a justification to trade.
Even with a plan, it’s hard to stay on track. A friend shared with me that after last Monday he received a message from their advisor asking if they remained comfortable with their current stock-bond allocation in light of the big one-day drop. This was the allocation in their retirement account – for people in their 40’s. This kind of call shouldn’t happen. If anything, a call should be made that either reinforces the idea that a plan is on track or that the volatility has revealed a weakness in the plan (either financial or emotional) that should be addressed.
2) Don’t be clever. To supplement the first point, times of intense volatility are not the right time to start thinking about new and smarter ways to manage your money. The most obvious technique for times like this is to “buy on the dip.” That is, take advantage of a downturn by buying more shares at a steeper discount. In principle, this is smart thinking – it’s one half of our buy low/sell high philosophy. But unless you have a finely-tuned trading strategy, this is harder to execute than it might seem. One challenge some investors find is that after they buy more when the market is down, say, 5%, they then get spooked when it keeps going down. For some, the general pain of loss is aggravated by the regret of buying more, so they feel compelled to sell. In other words, a bad situation can be made worse. Meanwhile, stay away from other clever techniques like shorting and put options. These are treacherous techniques for those not engaged in full-time trading.
Play it simple, not clever. We should all have some sense of how we respond to market-related stresses. Some people don’t blink twice at market volatility, while others can’t resist tuning in and stressing out. For those in the latter camp, consider investments that have a lower volatility profile. That’s easier said than done with equity investments in particular; there is always a “price of admission” for accessing the long-term growth potential of the stock market. That said, some managers and some strategies do excel at downside protection, at least on a relative basis. The rub with those managers is that they are less likely to keep up during sharp rallies. There’s never a free lunch.
3) Write a script. This is a topic that has increasingly come up with FAs I meet during my travels. In general, we’re pretty lousy at taking a long-term view. Impulse control is not natural for many of us. And that’s especially true during a stressful period, when our time horizons compress even further. I’m not seeding the lawn when the house is on fire. The endless abundance of information through financial websites, TV, and social media makes matters worse, as we tend to mistake data for actionable insight.
Thus, we need to come up with a plan – a commitment contract – with one’s advisor (or yourself, which is a lot harder) to address bad times before they arrive. Specifically, when the market is down 5% or 10% or even worse, what exactly are we going to do about it? Given the decline, your long-term plan, and specific investment choices, what should that conversation be about? At least one if not both sides of that phone call are likely to be emotional, so having something specific to anchor on will in itself be calming. You won’t be looking for a script because you’ll already have one.