There is no shortage of investment dangers for investors to worry about. From the impact of interest rate changes and reductions in corporate profits to slower economic growth and a potential recession, 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 buying and selling at the wrong time which leads to under performance.” So how can you avoid being your own worst enemy when it comes to investing?
Avoid the 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 in my opinion is the equivalent of allowing a physician to operate on you without performing a diagnostic process to determine how best to treat you first.
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, investors may feel that they are comfortable with a higher risk level in order to seek 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 mirror 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 life.
Stress test for the unexpected
How would your portfolio react to more changes 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 overreacting 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, maintaining 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, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com,www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.