The Emotions of Investing

Source: LCM Perspectives, September 15, 1997, Provided for illustrative purposes only.

Does Your Financial Advisor Have an Asset Allocation Process in Place to Maximize Your Portfolio Returns While Minimizing Risk?

Financial Advisors generally use two types of asset allocation strategies. These strategies are known as Tactical and Strategic.

1. Tactical Asset Allocation involves an element of market timing and moving in and out of various Asset Classes.

While this sometimes appears as an attractive strategy to investors, it has been shown that market timing does not work very well, is not very tax-efficient and costs investors over the longer-term.

Tell me if this story sounds familiar.

We know that over time, investments go up and down, but that is what makes investing fun, right?

Imagine that you are around a water-cooler or at a party, and a few friends are talking about a great stock they recently bought and are trying to convince you that it is a great buy.

Eventually, the pressure gets too much, and you buy it.

What happens after you buy it? The value of the stock goes up, and you’re feeling upbeat and like an investing pro.

Then, not unexpectedly, the stock goes down. After a few weeks of down, you are still all right. Then after it has gone down by 50%, you feel like the markets just aren’t for you. What emotion are you experiencing at this point? FEAR!

You may be affected by Recency Bias. As the value of your stock goes down, you may become concerned.

Recency Bias is, “…the tendency to think that trends and patterns we observe in the recent past will continue into the future.”

The value of a stock that has dropped in value will continue to drop. “I must sell my stock to reduce my losses.”

Should you sell, you will lock in your losses. Had you waited, you might have seen the trend reverse and the value of the stock move up? Now you’re kicking yourself.

But in this case, your investment turns around and it starts to go up.

Recency Bias sets in again, and you buy in order not to lose out on the projected profits.

Eventually, the stock gets back up to the same price that you paid for it. What emotion are you experiencing at this point? HOPE!

You may feel tempted to sell and get out without having lost anything, but then again, it is going so well that you decide to stay in for a little longer.

Now the third emotion kicks in — GREED! Now you put in more money into the investment. Then what happens?

What we can see from this scenario, if we look at the market as a whole, is that the high points are the ones with the most financial risk, and the low points are the places where we have the most financial opportunity.

The sheer volume of information and our emotions both hurt our ability to make the best investment decisions possible.

When we look at investing, there are certain truths that we know work.

For many retail investors, these emotions translate into action. They tend to panic sell when the markets are going down, selling the great stocks with the not-so-great stocks, because they do not have the expertise to understand what to keep, so instead of selling only the bad stocks, they tend to sell everything. These sales cause the market correction to accelerate as the inexperienced retail investor panics.

To buy when others are despondently selling and to sell when others are avidly buying requires the greatest of fortitude and pays the greatest ultimate rewards.[1]

– Sir. John Templeton

Professional Portfolio Managers take advantage of these market corrections. They would have long ago decided on what stocks they want to own and at what price. If the stock they want to purchase is slightly overpriced, they wait until the uninformed investors panic, bringing the price of the stock down to where it is attractive for them to purchase the stock.

In a market correction, the target company’s outlook will, in all probability, not have changed substantially. Only the emotional selling perspective in the market will have taken a hit. Portfolio Managers see market corrections as a buying opportunity, not a reason to panic.

Many Financial Advisors that favour market timing offer misleading facts such as:

“If you miss the 10 best days of the stock market over 30 years, you would actually have negative returns.” This is true. However, it is a one-sided argument, and fails to consider “what if I miss the 10 worst days?” One study shows missing the 10 worst days more than triples a buy and hold strategy. However, both arguments are flawed and misleading. For example, if you started investing in 1963, you would find that at the end of 1983 you had less money than you started with 20 years later. The point being is you need a long-term investment plan in place with a discipline strategy to make the outcome for your portfolio meet your own specific goals – and you should avoid these types of “what ifs.” [2]

Portfolio Managers understand that no one can time the market with such precision as to miss the 10 worst days of the market or to only invest in the 10 best days in the market. Instead of timing the markets, Portfolio Managers rely on a strategy known as Strategic Asset Allocation.

2. Strategic Asset Allocation is the philosophy and approach that involves setting up a target asset mix of various Asset Classes that provide investors with the maximum rate of return given their risk level.

The portfolio is rebalanced periodically back to its original allocation when it deviates from the original portfolio allocation due to differing returns from the various assets in the portfolio.

“The target allocations depend on several factors, such as the investor’s risk tolerance, time horizon, and investment objectives, and may change over time as these parameters change.

Strategic Asset Allocation is compatible with a buy-and-hold strategy, as opposed to tactical asset allocation that is more suited to an active trading approach. Strategic and tactical asset allocation styles are based on Modern Portfolio Theory, which emphasizes diversification to reduce risk and improve portfolio returns”.[3]

Research has shown that how a portfolio is constructed is responsible for over 90% of a portfolio’s return over time. Security selection and market timing are minimal contributors to a portfolio’s overall return.

This is a longer-term, more disciplined and tax-efficient process and the approach I recommend.

Source: Determinants of Portfolio Performance, Gary P. Brinson | L. Randolph Hood | Gilbert L. Beebower

So how do you find a Portfolio Manager that uses a Strategic Asset Allocation Process to maximize portfolio returns while minimizing portfolio risk?

Good question!

I cover this in my book Who’s Investing Your Money? – 7 Key Questions to Ask Your Financial Advisor. This book examines the various types of advisor registrations, their limits and abilities and will help you find the right advisor for you.

You have worked hard to achieve what you have. Make sure that you hire the right wealth advisor who comes with a family business or farm-aware team.

To learn how a Portfolio Manager can help you maximize portfolio returns while minimizing portfolio risk, please call me at (604) 855-6846 or email me at aspitters@pfcwealthsolutions.com

Who’s investing your Money? is available as a free PDF download at www.whosinvestingyourmoney.com 

Alternatively, the book is available from Amazon.ca as a paperback and Kindle version from this link: Who’s Investing Your Money? – Amazon

[1] “John Templeton Quotes.” Quotewise.com. N.p., n.d. Web. 01 Aug. 2019  http://www.quoteswise.com/john-templeton-quotes.html 

[2] “Portfolio Asset Allocation Investing Strategies Santa Barbara & Los Angeles Asset Manager I How to Invest, How to Protect Your Portfolio from Loss Risks & Free Investing Advice Stocks, Bonds, Alternative Assets.” Montecito Capital Management I Building Brighter Futures https://www.mcapitalmgt.com/portfolio.html

[3] “Strategic Asset Allocation – Investopedia.” N.p., n.d. Web. 01 Aug. 2019  https://www.investopedia.com/terms/s/strategicassetallocation.asp

 

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.