How to Avoid Common Investment Errors
Market volatility often brings out the worst impulses, creating the opportunity for retirement investors to fall victim to common mistakes. And these days, volatility is exactly what investors are experiencing. Equities moved from bull market to bear market, then back to bull market in record time last year. Market volatility has continued this year, with investor sentiment gyrating between optimism and pessimism about economic reopening, depending on the latest headlines.
Retirement investors should be aware of the following damaging behavioral impulses and take action to counteract them.
The Urge to Time the Market
Morningstar’s annual study of 20-year returns illustrates the perils of market timing. Investors in the U.S. equity market who stayed invested for the full 20-year period through the end of 2020 earned 7.4% per year, while investors who missed the 10 best days saw their returns drop to 3.3% per year.
Yes, although avoiding the 10 worst days would boost returns. But the best and worst days tend to be clustered together. That makes it nearly impossible to capture the best days while avoiding the worst days. You’d have to have a functioning crystal ball.
Market turbulence often creates investment opportunities, but there is a profound difference between making incremental portfolio changes to take advantage of opportunities created by market volatility and “all-in, all-out” strategies to try to call market tops or bottoms.
For most investors, the best advice is to avoid market timing entirely. Investors who can’t resist the temptation to market time should only do so for a small percentage of their overall portfolio.
Relying Solely on Past Performance in Selecting Investments
Despite the inclusion of required disclosures that past performance is no guarantee of future results, investors mistakenly expect recent patterns to continue and persist in chasing winners and abandoning losers. Performance often reverts to long-term averages, so chasing last-year’s winners perpetuates a pattern of high portfolio turnover, disappointing long-term performance, and investor dissatisfaction.
Being in the right place at the right time often plays a significant role in explaining investment success. For example, given widespread lockdowns and social distancing measures, 2020 was a challenging year for value funds that invest in economically sensitive stocks. This year has been much better for value managers, with economically sensitive stocks benefiting from reopening of the global economy.
Value managers weren’t collectively incompetent last year, nor did they become geniuses overnight this year. Consequently, distinguishing between skill and fortunate timing is an important dimension of investing. Investors should evaluate whether the winners were just in the right place at the right time or whether skill was the cause of an investment’s success.
Taking Investment Narratives at Face Value
Popular narratives can frequently become conventional wisdom that may endure beyond the point where the narrative and facts begin to diverge.
In the years leading up to the Great Recession, many investors believed that housing prices would only go up and that housing markets were more local than national in nature. Many investors clung to that narrative long after evidence to the contrary became apparent.
A different narrative began to dominate the bond market after the Great Recession. With interest rates lowered to levels not seen in decades, the consensus was that interest rates could only go up from what seemed to be unprecedented levels.
Both narratives proved disastrously wrong.
The best investors approach popular narratives with a degree of skepticism, seeking contrary opinions as part of their investment process. Many investors also aim to challenge the conventional wisdom by seeking insight from past events, as prior experiences may provide context into how frequently an event has happened in the past, the magnitude and the duration. For example, many investors who sought insight into the investment implications of the COVID-19 pandemic examined prior pandemics such as the Spanish Flu.
Reaching for Yield
With government bond yields at extraordinarily low levels, it’s natural to look for opportunities to obtain higher yields. Consequently, high-yield bonds have been popular, with investors obtaining a shrinking risk premium for moving down in credit quality.
Although the economic backdrop is encouraging for high-yield bonds, investors may underestimate the degree to which high-yield bonds are correlated to stocks and the thin margin of safety if the economic recovery stalls.
Reaching for yield is often a losing strategy, so investors should remain cautious when doing so and exercise selectivity about the types of high-yield investments they select.
Defining Risk the Wrong Way
For most investors, short-term moves in the market should not matter.
Most consumers have investment time horizons that should be measured in decades rather than days or months, given that longer lives lead to longer investment time horizons. Permanent loss of capital associated with making bad investments or selling at inopportune times is far more damaging than short-term market volatility.
Failing to maintain enough liquidity to meet unexpected expenses increases the likelihood of having to sell assets at inopportune times. Being overly leveraged also raises the vulnerability of being a forced seller, which was the unfortunate fate of too many real estate investors in 2008 and 2009.
Investors should revisit their investment time horizon and consider accepting more day-to-day portfolio volatility in exchange for higher longer-term return potential.
Awareness of behavioral biases can provide a roadmap for counteracting harmful behavior. Although mental shortcuts are helpful in day-to-day life, a slower and more methodical investment approach is likely to be a better recipe for investment success.
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