Many clients have asked me to identify the biggest risk to investing. I answer without hesitation. The biggest risk to investing is not the ups and downs of stocks or whether a recession is in the future. There have been many down markets in the past, and it’s relatively safe to assume there will be future down markets as well. In my opinion, the largest risk to portfolios is the investor himself.
Most of the emphasis placed on reducing risk is focused on asset allocation and diversification. While the ratio of stocks-to-bonds is very important, it is not a new concept. By now, all investors should know not to ‘put their eggs in one basket.’ Many would agree that holding a portfolio which is broadly diversified among many different asset classes is just the starting point for a successful investing experience
Advisors tend to focus on charts and graphs when working with clients. They will talk about various ratios and the correlation of their portfolios to prove a point. These numbers are important, but my belief is clients want advisors to help make sense of all the financial noise, not contribute to the confusion. The way advisors can add real value is to help explain how investor behavior shapes investment success.
After the market dropped in 2008, many investors felt fear and panic and sold out of the market entirely. While many investors felt better in cash, the market rebounded over 25% in 2009 and almost 15% in 2010. Those that sold out may have missed on these returns. Behavioral finance helps explain how investors’ reactions to the markets can help or hamper achievement of their investment goals. This is the most important concept to understand when becoming a successful investor.
It is common knowledge that to make money you purchase shares at low prices and then sell them at higher prices. Then why is this such a difficult feat to accomplish in the real world? The answer is investors let their emotions get the better of them, and make decisions based on what feels good. Looking back at just the last decade or so we can see two prime examples of this:
Many investors were convinced there was endless money to be made in technology stocks. After a few successful trades investors were hooked and completely convinced that technology and internet stocks would continue on their meteoric rise indefinitely. Millionaires were made every day. Then the unfortunate happened. The bottom fell out. Investors that were caught up in the euphoria were most likely the ones who lost the most.
When housing prices continued to climb some investors bought rental property with little or no money down. There were commercials touting how to invest in real estate like a pro. A false sense of confidence that housing prices would never fall fueled a large run-up in both real estate and the market. Then the unthinkable happened. Housing prices dropped and many of the investors that felt irrational exuberance, were likley brought back to investing reality.
When the market is rising, and the enthusiasm is building, it is easy to buy into the market. However this goes against the eternal rule of investing, buy low. On the other side of the equation, it is very easy to get caught up in the negative headlines and countless reports on how and why the market is dropping like a rock. Each down market is caused by a different reason; however, the market has always rebounded. Of course this is not guaranteed, but there is something to say for 100+ years of history. Making long term financial decisions based on short term knee-jerk reactions is a formula for mistakes.
The next time you hear of the newest golden investment, perhaps one that has recently exploded in value, I would urge caution. And the when everyone is running for the exit, it might be a prudent time to invest in some solid companies at low prices. Warren Buffett said it best, “Be fearful when others are greedy, and greedy when others are fearful.”
Joseph C. Conroy, CFP® is a CERTIFIED FINANCIAL PLANNER™ with Synergy Financial Group in Towson, MD.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Stock investing involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. No strategy assures success or protects against loss. Securities offered through LPL Financial, Member FINRA/SIPC