In the spirit of Back to the Future II, and its scattershot accuracy of what 2015 would bring, I’m offering you a true trip back in time. So, get in the DeLorean, Marty. Where we’re going, we don’t need roads…
It’s the summer of 2008. I’m a savvy young Staff Sergeant with a high-and-tight haircut you can set your watch to. One of my best friends, a Soldier of mine, has just asked me about investing. I had been active in the markets for four or five years at that time and had moderate success thus far. She had a few thousand bucks that was sitting in a savings account. With her asking, I encouraged her to put it to better use by investing in stocks.
When a financial advisor meets with a client for the first time, the meeting will usually be one to three hours long—complete with W-2s and your latest 1040. Money is very personal; understanding a client’s thoughts and behaviors is the single most important set of information an advisor needs to know when providing guidance. A financial advisor will start the conversation with questions like:
“What does wealth mean to you?”
“What are your financial goals?”
“If you woke up this morning and saw your portfolio was down 20%, what would your reaction have been?”
“Do you have any pictures of your kids? Are you planning on having any more?”
These types of questions are essential to understanding your client’s attitude toward money, their goals, and their risk tolerance. If you don’t understand behavior, you don’t understand investing. For a long time, I didn’t understand behavior.
A day after we initially broach the subject, I hastily recommend that my Soldier invest in mutual funds. She doesn’t quite have the insight or appetite to start in individual stocks, so I recommend a trio of funds in Natural Resources, Emerging Markets, and Small Caps in relatively equal portions. I leave her with a caveat. I say, “the market is down significantly these past 6-9 months, so you’re paying a lot less than you would have then. However, you have to understand that this is a long-term thing. The market might sell off a lot more, but over the long run, I think you’ll do very well.”
She replies, “Yep, I understand.”
It’s easy to say things like, “be greedy when others are fearful, and be fearful when others are greedy.” However, what we do in practice is almost always the opposite. In practice, most all of us follow the crowd—very few of us are truly contrarians. We buy into euphoria when stocks are usually near a peak and sell when we get scared, hoping to save whatever we have left. This is where the phrase, “stocks climb a wall of worry” comes from. As counterintuitive as it sounds, stocks usually rise so long as there is a reason not to buy. Like today, we have Russia invading Ukraine, Ebola, China slowing, Fed hikes next year, etc., yet we continue to hit all-time highs each day. There’s always somebody “on the sidelines” for one reason or another. The “dry powder” sitting on the sidelines is what keeps the market stair-stepping higher for years as worries abate and we get “risk on.”
Three months ago Fidelity performed an awesome study where they found which investors performed best over time. The best performing accounts were those where the account owner had either A.) Died, or B.) Forgotten they had an account. Why? Because when folks actively manage, this is what happens:
Don’t think so? Look at this chart from Bernstein Research showing the performance by asset class vs. the average investor.
The average investor’s drastic underperformance would be a mathematical impossibility if not for behavioral biases. The fact is, people get scared when their portfolios drop in value. When a year’s worth of salary evaporates in a day, our amygdala interprets this as an attack, initiating a fight-or-flight response. Fighting the market is hard impossible. Despite what CNBC headlines would have you believe, markets are not some sentient, breathing, responsive creature that gets happy and rises in price or gets mad and farts in your breakfast. Every seller has a buyer, and the “market” is just a collaboration of recent trade prices. You can’t fight this. Ninety years ago, the Rockefellers tried to fight Black Tuesday with huge, across-the-board buy orders, only to get totally swallowed up in a sea of panic (Thankfully, the Rockefeller’s survived.) So, because we can’t fight the market, we “flight” the market by selling out.
It’s late spring, 2009. The markets are in full recovery mode. After bottoming at 666 (how appropriate) on March 6th, the S&P stages a 20% rally over the next eight days and a subsequent 20% rally over the next two months. We know, now, that this rally went on to more than triple the S&P over the next five years. I’m at my Soldier’s house and I comment, “ you must be doing pretty well, markets have rallied huge over the last couple months.”
“No. Sold it a couple months ago. It just kept going down.”
Well, here we are. Of course it didn’t “keep going down.” Had she stayed in the game, she would probably be up some 150% with dividends. Who’s fault is this? Mine, of course. I was hasty in advising her to start investing in markets. This was clearly money she couldn’t afford to lose. And, not only did I not understand her risk tolerance, but I didn’t understand that most folks don’t understand their own risk tolerance. When markets are stable/rising, everyone has a high risk tolerance. When markets fall, most of those self-identified cowboys get shaken out at the first sign of panic. So, what can you do to understand your capacity for handling volatility? Try this:
Steps to Identify Your Real Risk Tolerance
- Pull up whatever you use to track your net worth or your investment portfolio. For a lot of us, this is something like Excel, Mint, or Personal Capital.
- Actually change the numbers in your spreadsheet/screen to reflect a 50% drop in equity prices. Literally, change the actual numbers. If you can’t change the numbers, then add a debt line (or similar) to get the same adjustment.
How do you feel? Are you getting sick? Do you need an ambulance? Do you need a brick? We have this thing at our firm called the “Brick Indicator.” It means that whenever you feel like you want to drive to your advisor’s office and throw a brick through his car windshield, then it’s time to buy.
A 50% drop in equities would probably wipe out $100k in net worth for me. When I changed mine, just now, my mind went back to about five years ago, when my net worth was at that level. I remember it. I remember where I was living and working. Life was good. I think I would be very frustrated. But, more than that, I think I would buy.
Want a quick alternative method to the steps above? Just ask yourself what you did in 2008/2009. Did you sell? Did you buy? Odds are, you’ll do that same thing again. I was buying hand over fist; that’s why I stay invested in stocks.
Thanks for reading!