Anatomy of an Investment Mistake
July 22, 2016I saw an email from a soon-to-be-retired employee recently, saying that he thought that he made an investing mistake and was looking for some help in correcting it. Here’s the mistake he made. When the stock market tumbled for a couple days because of the British exit from the E.U. (Brexit), he jumped out of the stock market. He moved his portfolio from 60% stocks/40% bonds and cash to 100% stable value because he was afraid the market would continue to drop like it did in 2008.
Well, after two days of going down, the market went back up and within two weeks, it was higher than it was the day before Brexit. The question he asked was “When should we get back in: when it drops to the level when we got out or lower?” There are a few flaws in his thought process.
Issue #1: Selling (or buying for that matter) based on emotions and news events usually ends poorly. In not too distant memory, we have seen the dot-com bubble burst, 9/11, Enron, the housing market collapse, the stock market collapse of ’08 and an economy that is 7+ years into one of the most lackluster recoveries ever, and the stock market is near all time highs! Markets go up. Markets go down. But over time, there has historically been an uptrend given enough time.
One of the things I tell people when they are worried about how the market will respond to a news event is “emotions are the enemy of good decision making.” Yeah, it’s not inspirational. It doesn’t rhyme, and it’s not all that compelling as a standalone statement. But it’s true, and I’ve seen it have horrible consequences for people time and time again.
If you are thinking about changing your investment mix based on a news event, don’t! Go take a nice walk, turn off the TV, play your favorite tunes and let some time pass. Markets overreact…in both directions. If there is a huge sell-off on Monday, chances are that logic and reason will come back into the market, and there will be a few up days after a massive sell off.
Cool your jets and maintain your long term asset allocation. Talk with a financial professional if you have one in your life. Don’t let your emotions be the enemy of your decision making process.
Issue #2: In his question, he assumes that the market will, one of these days, be lower than when they sold off the stock portion of their accounts. It may never be that low again. People who sold in ’08 and wanted to buy back in when the market got that low again are still sitting around waiting for that to happen. Their wait may be eternal (or not).
The logical flaw in this argument is a lot like the “sunk cost fallacy.” You’ve already made the sell decision and are now tied to the results of that decision emotionally. Looking into the rear view mirror isn’t helpful in this case. Look forward. It’s a difficult skill to apply, but don’t allow yourself to fall into the sunk cost fallacy.
Issue #3: The reason he sold off a big chunk of his 401(k) and went to stable value is that he is considering retirement in the not too distant future. It makes sense to want to be more conservative in that case but it’s too drastic of a change. If he had been considering retirement for some time now, maybe a few years ago would have been an appropriate time to start making small changes to his long term asset allocation.
For instance, I meet annually with someone who has a retirement goal of 12-15 years. She was 100% stocks and 0% bonds and cash when we first met 5-6 years ago. Rather than selling her existing holdings, she changed her future 401(k) contributions to 75% bonds/cash and 25% stocks. She recently moved future contributions to 100% bonds/cash, and when she hears that the stock market hits a new high, she moves 1% of her account to stable value. Her goal is to be at 50% stocks, 50% bonds/cash at and during retirement.
Do you know your long term asset allocation preferences? Do you have a plan in place to shift from where you are now to where you want to be when you’re 98 years old? Review your asset allocation today, see if it’s consistent with your investment risk tolerance and then develop a plan to get from point A to point B over the course of time. Remain patient and don’t let emotions get in the way.
Over the course of time, we all make mistakes. I have, you have, and the odds are high that we’ll make even more in the future. But some mistakes are preventable, and we can hopefully learn from the mistakes of others so that we don’t make them as well. If you can remain emotionally detached from your investments when bad news is happening, avoid the sunk cost fallacy and have a clear vision about your long term investment strategy (and stick to it), you will put yourself in a great position for long term financial success.