Beware of high water thinking

0

A few weeks ago, I received a call from a frantic friend after opening her June portfolio statement. She hadn’t checked her account since the start of the year and was appalled that it had lost about a quarter of its value. She told me, “I lost more money in six months than I made in a year!” Maybe I shouldn’t own so many stocks. What should I do?”

I analyzed his portfolio and noted that even with the recent decline, his investments have paid off well over time. I told him, “Even with the recent drop, your portfolio is still 25% above what it was two years ago and more than double what it was ten years ago. You did well, and to enjoy the highs, you have to face the lows. With this change in perspective, she felt better and we had a calm discussion about the appropriateness of her (probably too aggressive) asset allocation.

My friend isn’t the only one who feels like she’s lost money even though her wallet is up – it’s common to think of dips over highs as losses. These days most of us are in the same boat – we have (hopefully) enjoyed many years of gains on our stock investments, but now find our portfolios falling from their highs (I grimacing when I check my investment account, remembering its value at the start of the year.)

Comparing the current value of a portfolio to its high point is not productive. A decline in value, even if the portfolio has performed well over the long term, generates fear and anxiety and makes it more difficult to practice good investment behavior.

What to do instead

Instead of comparing your portfolio to a recent higher value, take a step back and try these strategies instead:

1. Zoom out. In the short term, investment markets are unpredictable and chaotic. News, events and investor psychology (stock memes, anyone?) make the market go up and down. But over the long term, the market consistently delivers positive returns.

Specifically, since 1871, the stock market has delivered a positive real return 100% of the time over 20-year periods and 89% of the time over 10-year periods. But over shorter time frames, the stock market is much less consistent, delivering positive quarterly returns 63% of the time and positive daily returns only 55% of the time.

As I did with my friend in the example at the beginning of this article, do some research to find the value of your portfolio five and ten years ago. If you’ve been steadily increasing your investments and buying stocks in a diversified way, your portfolio has probably grown well over those longer periods. Realizing this will help ease any anxiety that recent declines may have caused you.

2. Be aware of two cognitive biases that don’t help. A few biases are partly responsible for the pain we feel when the stock market falls from a high point.

The first is loss aversion, the theory that people feel the pain of loss about twice as much as the pleasure they feel in the midst of a gain. This asymmetry is part of the reason we react strongly when we experience financial loss. Thus, seeing our portfolio falling from a high point worries us, even if it is rising over the long term.

Another is the concept of anchoring, which occurs when we have a particular number or starting point in mind. Investment manager James Montier likes to ask people to write down the last four digits of their mobile phone number (you might want to do that now) and then ask how many licensed doctors there are in London (go- y, guess). He finds that “those with phone numbers of 7,000 or more think there are around 8,000 doctors working in London, while those with phone numbers of 3,000 or less think there are around 4 000 doctors in London”. How many doctors are there in London? About 50,000.

What anchoring bias teaches us is that we cling to numbers, sometimes unconsciously. So, if we see that our portfolio is worth $1 million, that number sticks in our heads and any drop looks like a loss.

3. Focus on your investment plan. When you feel the painful emotions of diminishing values ​​in your portfolio, it’s best to fall back on your documented investment strategy. A best investment practice is to have an “Investment Policy Statement” (or “IPS”) in which you document the investment strategy and asset allocation. Your IPS will provide safeguards for your behavior and improve your returns.

Share.

About Author

Comments are closed.