The most dangerous risk to your nest egg may be yourself

EN-AB322_INCOME_J_20150310143849[1]The most dangerous risk to your nest egg may be yourself

There is no shortage of investment dangers for investors to worry about. From the impact of interest rate hikes and reductions in corporate profits to slower economic growth overseas and falling commodity prices, many investors ponder what the cause of next market decline will be.  In fact, with volatility creeping higher after years of below average fluctuations, some investors have become a little more jittery.  While there are always significant risks for investors to consider before updating an investment plan, one of the biggest risks to your portfolio may actually be yourself.  That’s right – you could actually be your own worst enemy when it comes to investing.

You may be asking why you might want to monitor yourself more than the latest economic indicators. It’s simple – human behavior and emotions have the ability to significantly derail your long-term investment plan.  The Behavior Gap, a term coined to describe how investors tend to sacrifice significant market returns due to poor market-timing decisions, can negatively impact results in the long-term.  In fact, many academic studies suggest that this “gap” can be quite large.  According to Boston based consulting firm DALBAR’s Qualitative Analysis of Investor Behavior study, investors may sacrifice up to 4.66 percent of returns due to poor market timing choices.  DALBAR notes “Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally. That irrationality leads to the buying and selling at the wrong time which leads to underperformance.” So how can you avoid being your own worst enemy when it comes to investing?

Focus on goals rather than market noise

Too often, investors choose their investment mix without having a comprehensive financial plan in place. (Remember, a risk assessment questionnaire does not qualify as a financial plan). How can you possibly know how to invest your money if you are unaware of exactly what you need it to do for you?  Remember, money is simply a tool to help you focus on the things that matter most in your life.  What are the goals you have for you and your family both short and long-term?  What do you want to accomplish over the course of your life?  How do you measure success?  Investing without clearly defined goals and a detailed financial plan is the equivalent of allowing a physician to operate on you without performing a diagnostic process to determine how best to treat you first.  With only 31 percent of investors having created a comprehensive plan before they retire (CFP Board), too many investors end up selecting their investment strategy without a clearly defined financial life plan.

Avoid overreacting to gains & losses Allowing emotions to rule your decision making can lead to the type of irrational responses noted above.  In fact, some investors even allow their risk tolerance to be manipulated by market performance.  For example, during extended periods of positive performance (like we have seen since the financial crisis), investors may feel that they are comfortable with a higher risk level in order to achieve higher returns.  The problem is that these are often the same investors who allow periods of negative performance to force them to re-evaluate their risk level – sometimes getting drastically more conservative after they have already experienced a decline.  Would you consider selling your home simply because it declined in value by 10%?  Remember, your risk tolerance and performance should not vacillate based upon what the market is doing.  Instead, consider basing your risk tolerance on your time horizon and long-term investment goals.

Avoid rear-view investing

While basing decisions on past performance may seem logical, past performance gives no indication as to what future results will be. From chasing last year’s best performer to avoiding investments simply because they may have declined, investing by looking in the rear-view mirror can negatively impact long-term results. Instead, consider evaluating the merits of any investment based upon the long-term impact to your financial plan.

Plan for unexpected

How would your portfolio react to a continued rise in interest rates? What might the potential impact be on each of your holdings to a global decline in equity markets?  If you are unable to answer these questions you might benefit from a portfolio stress test.  As a process designed to model the unexpected before it happens, stress testing can help investors to understand whether their portfolio risk level is appropriate for their unique goals before something unexpected occurs –possibly limiting the type of panic that can lead to irrational behavior.

Focus on the big picture

Focusing on your goals rather than overacting to short term fluctuations may be a better approach to remaining on track. Consider establishing your financial plan so that your portfolio is aligned with your goals in life.  Revisiting your plan, maintain discipline and stress testing for unforeseen outcomes may all help you to avoid allowing your emotions to get the best of you.  Since everyone’s situation is unique, consider speaking to your financial adviser to determine the most appropriate approach for you.

Kurt J. Rossi, MBA is a Certified Financial Planner Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.Independentwm.com and www.bringyourfinancestolife.com  - LPL Financial Member FINRA/SIPC.