How to Protect Your Portfolio from Emotional Responses
It has never been harder for investors to focus on the long term. We all soak up terabytes of mostly irrelevant information on a daily basis, which sparks emotional feedback loops, which keeps the financial porn blaring, and our dry eyes scrolling Twitter. The exaggerated emphasis on subtle changes in markets, that may matter to a small group of traders who spend all day staring at four screens, probably has no impact on whether you reach your retirement goals. It does sell advertising though.
We all know that investing is an uneven and crooked trail to our goals. Our portfolio will trudge through mud and seem to go nowhere, fall into ditches that it needs to climb out of, or one of the companions in the portfolio may move too slowly and hold it back. In spite of these distractions, we must look ahead and be careful along the way to stay on the path, or the results can be grave.
If we contemplate the periodic market challenges like stretches of low or no returns, bear markets, underperforming assets, rising interest rates, inflation, or any of the myriad tribulations as our investments amble along, it is hard to divorce our feelings from the performance of our portfolios. The predictable emotions of apathy, concern, terror, despondency, and ever so occasional enthusiasm, will be present. (We are rarely very excited by a good performance. That is just what is supposed to happen, right?)
I would like to present a framework to follow when the daily distractions, as well as significant market disruptions, conspire to derail us from our fertile future. It is important to have this structure established in advance of serious market challenges. This is not a process to talk you off the cliff, it is a means to never approach the cliff at all.
This method, when applied to many difficult markets, will provide a structure to curb our instinctive emotional responses that can prove destructive over time. I am going to look at how a portfolio is designed to deal with the specific market condition, the history behind similar circumstances, how we are likely to react, another way to look at the issue, and lastly make a pre-commitment about what to do when it actually happens.
I have identified a list of market challenges that have derailed plans in the past that is certainly not comprehensive, but if you can tackle these you can use the same framework to work out others. Rising interest rates, inflation, periods of low or no returns, out-of-favor assets, significant market declines, not participating in an asset bubble, and financial noise are a good start to a list of what might evoke emotionally-driven action.
In a recent study my firm conducted in conjunction with the Investments & Wealth Institute®, we learned that over half of investors think we are at risk of significant market decline. Below I will go through a series of questions to consider, using the answers to address the research findings.
How is the portfolio designed to handle significant market declines, which all long-term investors will likely face? (If the portfolio is not designed to absorb impact, then we have a whole other issue at hand…) Describe how each asset performing its specific job in the portfolio is like the spokes of a wheel on opposite sides of the hub of correlation keeps it rolling. Some parts should prosper in market declines, while those on the opposite side of the wheel move with the market.
What is the history of this market challenge? Generally, markets have strong rebounds right after significant declines, seemingly designed to shame those who moved to cash in fear without a process for reentry. While no two markets are the same, there are trends, like the bounce after a bust, that have historical precedence worth noting.
What is your likely emotional response when faced with this challenge? If you are like most people, you will be scared and want to sell out to avoid more pain. It may feel like your very life is being threatened. Look around and you will probably see that you are not alone in your fear. Now you can move to externalize this fear as something that is natural and larger than yourself. Since of course, you do not want to be caught up in the emotional riff-raff you can observe it as a phenomenon and rise above and look for the counterintuitive move
Is there another way to look at the challenge as an advantage to be seized upon? Reframing a drop in the market as a buying opportunity where stocks are on sale is a means of taking some of the teeth out of this fear. Every market presents an opportunity if you are prepared for it in advance.
What are you going to commit to doing when you face this particular market condition? Having a plan in place for what you will do when the challenge arises does not necessarily mean you will be able to execute it perfectly, but it will increase the chances that you will get through it with your plan intact. If you are working with a financial advisor, both have a responsibility. responsibility is to embrace the idea that changes in the investing terrain are a constant and to embrace this opportunity. The advisor’s responsibility is to take the counterintuitive move of rebalancing into the risk assets, which will likely feel terrifying and wrong.
The military makes considerable and constant investments in training because they have seen that it is very difficult for one to perform at a level above which they have been trained. The key is to build these educational fire drills while markets are calm and the particular threat is not currently looming.
How does that slightly vulgar adage go? Prior Planning Prevents Poor Portfolio Performance…
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