Panic and Greed: Ineffective Investment Strategies

If markets are good at one thing, it’s reminding investors that stock prices don’t simply go up, uninterrupted, forever.

Markets do drop.  That’s an unavoidable part of investing.  What matters is how you respond.  Or, more to the point, don’t respond.  Because if you’ve built a portfolio that matches your time horizon and risk tolerance when markets are calm, then a surge in turbulence may not feel so rough to you.

That’s not to say you should never respond to market moves.  Rather, it’s more of a reminder that good planning is like a preemptive dose of Dramamine – it can help neutralize some of the nausea when the turbulence hits.

Panic and greed

When it comes to panic, the most obvious example is trying to dump investments when the market is dropping.  This is a great way to invert the old adage about buying low and selling high.  Never before has information about the global economy and markets been more readily available and disseminated.  As a result, global markets have become more interconnected.  In turn, our reaction mechanisms are heightened – but not necessarily to our advantage.  Investors should rarely, if ever, react in a purely emotional fashion to a dramatic short-term move in the market.

Greed can also lead us astray in a number of ways.  First, there’s the temptation to load up on aggressive higher-risk assets in the hope of a big payoff.  But there is a dark side to an aggressive posture’s potential higher returns: the risk taken in getting there. Aggressive portfolios’ higher historical returns have had a much wider range of returns – that is, higher variance and volatility.  And most importantly, those higher returns typically are generated through “stick-to-it-iveness,” not lucky bets.

Then there’s the temptation to try to “time” markets.  It’s enticing to try to catch the next big investment wave (up or down) and allocate assets accordingly.  But there are very few time-tested tools for consistently making those decisions well.

It’s also important to consider how the two impulses can work together, with today’s greed paving the way to tomorrow’s panic.  Investors may think they understand their risk tolerance – until they don’t.  There’s a big difference between financial risk tolerance (the ability to financially withstand volatile markets) and emotional risk tolerance.  The gap between the two is often quite wide and only becomes evident in tumultuous market environments.

Relying on the rearview mirror

Too often, investors use a rearview mirror to make investing decisions, treating past performance as a guide to future results.  I’ve known plenty of older, close-to-retirement investors who have stuck with their aggressive investment stances because they were accustomed to the thrill (and perhaps, past success) – with no thought for how a loss at the start of retirement might affect their savings.  I’ve also known plenty of young investors who couldn’t stomach the thought of any losses, despite having many decades in which to potentially recover and accumulate returns.

Many aggressive investors have learned the hard way that they had a lower tolerance for a big loss in the short term than they thought.  And to maintain their aggressive allocations, they generally had to double down on the asset classes that generated those steep losses, and shift away from the asset classes that had weathered the storm.

Conservative investors should heed the lesson, as well.  A conservative portfolio’s lower historical returns have come with significantly less drawdown and volatility.  For some, the lower return is worth the sleep-at-night benefits.  But the reality is that many investors want all of the upside when markets are performing well, but none of the downside when they are not.  That is highly unrealistic.

A mirror is a valuable tool, but only when it is turned on yourself to judge your own circumstances: tolerance for risk, time horizon, income needs, etc.

The closest thing to a “free lunch”

There are very few free lunches in investing (or in life, for that matter!).  Asset allocation, diversification and periodic rebalancing are as close as you get.  One of the most important areas where financial professionals offer advice is the development of a long-term strategic asset allocation plan, which can help you create an appropriately diversified portfolio.

Rebalancing – that is, maintaining your target asset allocation by adding to underperforming asset classes and trimming outperforming ones – goes against the emotions of fear and greed that often drive investment decision making.  It may be challenging to sell investments that have done well and add to holdings that haven’t performed as well, but developing and maintaining the right long-term asset mix is by far the most important set of decisions an investor will ever make.  Rebalancing forces us to do what we know we’re supposed to do, which is “buy low, sell high.”

Patience and stick-to-it-iveness

Admittedly, the development of a long-term strategic asset allocation plan isn’t the hard part – rather, it’s sticking to it that often becomes the real challenge.  That can be especially difficult when markets are volatile.  But if we learn from our mistakes, use our brains over our hearts and look to our portfolios as rebalancing guides, we can expect a more successful investing future and maybe even get a free lunch along the way.