Understanding Volatility Can Make You a Smarter Investor

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wall-street-flagI never thought much about the psychology of investing early in my career. Nor did I consider it important. Clients were hiring my firm for our expertise and would remain confident in our abilities whether the stock market was doing well or not. Then came the tech wreck of 2000 — 2002. We were surprised at the number of clients, who wanted to sell and wait to see what happened. Even though we pointed out that they would be buying high and selling low, that this would be market timing and no one can accurately time the market, or that downturns in the market are normal and would eventually be followed by a recovery, some of them sold anyway.

The stock market did recover from the tech wreck and I learned a valuable lesson about behavioral finance. It didn’t matter how good our advice was while the markets were doing well if clients panicked and sold out when the market went down. Dalbar has been studying investor behavior for over 20 years and has found that bad behavior has a huge impact on returns. Their most recent study[1] found bad behavior cost investors 8 percent in 2014 alone. No one would choose an investment strategy of buying high and selling low – yet they do it over and over again. Nobel Prize winner Daniel Kahneman, considered the founding father of behavioral finance, says “We’re blind to our blindness. We have very little idea of how little we know. We’re not designed to know how little we know.”

Beginning in 2003, we started a plan to continually educate our clients about investor behavior and the investment strategy we had in place to take advantage of market volatility. A semi-annual market update seminar was launched to remind clients of the long-term view. This seminar was designed not to forecast markets but to offset the doom and gloom that seems to dominate the financial press. There are a lot of good things happening every day. We just don’t always hear about them. It’s easy to fall into the trap of thinking nothing is going right and the market should drop because everything is bad. Quarterly review meetings also became investment strategy review sessions. Clients were reminded of how their balance between stocks and bonds was a tool designed to buy low and sell high simply to keep their portfolio in balance.

The great panic of 2008-2009 tested our preparation. The stock market drop was swift and significant. There were just as many panic calls from clients. A typical day from January to March in 2009 was spent on the phone with a client talking them off the ledge. We didn’t save everyone. However, being able to remind them of how their investment strategy is designed to take advantage of downturns helped save most of them. The education process helped but we needed to do more.

Over the past five years we added a client fire drill to our onboarding process with new clients. The fire drill is repeated with existing clients at some point each year during a quarterly review. We use Dimensional Funds’ research to show the client what the return on their stock to bond allocation could look like in a bad year. The worst one-year period for a 60% stock/40% bond portfolio was the period March 2008 to February 2009, which resulted in a loss of 32.1%[2]. A fire drill is when we ask the client how they would feel if their $1 million portfolio shrank to $679,000 in a bad year. This is a powerful wake up call. It prepares clients for the down market that’s coming in the future. When the down turn comes, we’ll be able to remind them of this conversation. Downturns are a normal part of the market and that their investment strategy is designed to take advantage of volatility through rebalancing. Many investors have the mistaken belief that an adviser should get them out of the market before it drops. Our fire drill explains the fallacy of market timing and how we will embrace volatility and use it to our advantage.

Market volatility is unsettling, but the real harm comes from bad behavior by investors. Volatility is a friend to the long-term investor who operates with discipline. For much of the past five years, investors have become spoiled by the market’s low volatility. The streak of low volatility ended on August 20th as the stock market entered its first correction since the fall of 2011.

Living with a market decline is not easy, but if you understand the following key lessons, you will be a more intelligent investor:

  • Market declines are a normal part of investing.
  • No one can predict consistently when market declines will happen.
  • No one can predict how long a decline will last.
  • No one can consistently predict the right time to get in or out of the market.

Uncertain times like these are the reason we build diversified portfolios for our clients. While diversification can never eliminate all the pain, we believe our fire drills comfort clients to know we have planned for events like these and will rebalance their portfolio as appropriate.

Rick’s Tips:

  • A recent Dalbar study found bad behavior cost investors 8% in 2014.
  • A moderate allocation of 60% stocks and 40% bonds declined over 30% during the great panic of 2008-2009.
  • Market declines are a normal part of investing.

Sources:
[1] Qualitative Analysis of Investor Behavior, 21st Edition, DALBAR, April 2015
[2] Matrix Book 2015, Dimensional Fund Advisors

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