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Prepare for Pain

Joe Kesler  |  November 19, 2020

WHEN I THINK about investment advisors selling high-fee products, it brings to mind the story of two politicians who were shouting at each other. One of them stands up and screams, “You’re lying!” The other one answers, “Yes, I am, but hear me out!”

In my 40 years of investing, I’ve bought into some questionable sales pitches. You’ve heard them: “The easy money’s been made. It’s going to be a stock picker’s market going forward.” Or: “Only losers are satisfied with just earning the market averages, and we want to put you in funds that beat the averages.”

Fortunately, this intellectual battle is over for those everyday investors who are paying attention and have adopted a long-term buy-and-hold philosophy. The folly of investing in the latest hot mutual fund or stock has been debunked thanks to wise sages like the late John Bogle, founder of Vanguard Group.

He succinctly described his long-term investment philosophy using index funds: “[T]he winning strategy is to own all the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return they generate in the form of dividends and earnings growth.”

But there’s another ongoing battle that’s waged in the minds of long-term investors—and it’s less intellectual and more psychological. This battle involves the inner voice that starts talking to us every time there’s a stock market downturn that plays on our fears and doubts. I’ve watched investors over the years cash out of the market just as it bottoms. When stocks rebound and recoup their losses, the regret of bailing out at the bottom haunts these investors.

There’s a number of reasons investors make this same mistake time after time, but I want to focus on two of the big ones: failing to accept in advance the psychological cost of being a buy-and-hold investor and failing to manage our investment time horizon.

Consider an analogy from the exercise world. My first job after college was working for the Department of the Treasury as a bank examiner. I traveled around the Midwest from bank to bank and was given an expense account—and that’s where the problem started.

Growing up, I can only remember going to a restaurant a few times with my parents. When I was given that expense account, I found myself in heaven every night, enjoying one buffet after another, all at government expense. Even with the metabolism of a 23-year-old, I began to pack on the pounds.

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Fortunately, I worked with a marathoner who ran every day after work. Because of his influence, I took up the sport and have now kept it up for more than 40 years.

The benefits have been great. Immediately, I shed the unwanted pounds and learned how to manage stress better. Longer term, I think regularly running over the decades has contributed to my current ability to still run and hike in my 60s. And there are occasional moments of extreme delight, as I run while watching a beautiful sunrise or just feel one with nature as the endorphins kick in.

But the costs have been real, too. Sacrificing an extra hour of sleep before work was tough. Running in the cold Montana winters can be bone chilling. On some days, I just don’t feel like it, but I know that’s the price I have to pay to achieve the health benefits I want. After 40 years, I also know it works and that the costs are worth it.

This is how things work in life more generally. There’s a cost to be paid to achieve success. But for some reason, we don’t expect to pay a big psychological price to be a successful investor. My contention: Not considering the psychological cost of down markets may be the primary reason some bail out of stocks at just the wrong time.

We objectively look at the evidence of how the market has performed over long periods of time, and we decide we want to invest and grow wealthy, too. We don’t, however, properly factor in the inevitable cost we’ll endure when those dramatic dips in share prices occur. When our 401(k)’s value drops sharply, the resulting fear, regret, embarrassment and self-doubt are costs that aren’t easily factored into our analytical models. In fact, until we actually experience it, it’s hard to imagine the stress of a downturn and watching our retirement nest egg shrink by 30% in just a few weeks.

During these emotional times, we’re especially susceptible to the siren call of a market-timing pitch that promises all the market’s gains without the stressful losses. Problem is, those temporary losses are the price that has to be paid to enjoy the long-term success we desire.

I like Warren Buffett’s advice to see a market decline as stocks going on sale. That’s a great way to look at it—unless you’re at the end of your prime earning years. If we need to cash out of stocks in a down market to pay for retirement or other expenses, his advice doesn’t help at all. Result: We need a second strategy to mitigate this risk.

For those of us toward the end of our careers, I really like combining long-term buy-and-hold diversified stock-index fund investing with the low stress benefits of a bucket approach to managing our finances. In other words, to keep from panicking when the market drops, try to keep stock investments in a “bucket” that you don’t need to draw on for at least five years or, better yet, for 10 years. Meanwhile, funds you’ll need in the near future, such as buying groceries next week or replacing the car next year, should go in less volatile places, like short-term bond funds or money market accounts.

Kiplinger’s magazine recently had a chart listing the probability of negative returns for the S&P 500 over various time periods since 1929. While there’s a 46% probability of loss on any given day, the loss probability drops steadily over time and is just 11% over five years and 6% over 10 years.

Based on these probabilities and my bucket approach, when I lose money in the stock market, I can honestly assure my wife that it’s money we don’t need for several years and we have a high probability of gaining it back, plus some. That’s a much better conversation than explaining why we can’t take the vacation this year because I just lost our travel budget.

Joe Kesler is the author of Smart Money with Purpose and the founder of a website with the same name, which is where a version of this article first appeared. He spent 40 years in community banking, assisting small businesses and consumers. Joe served as chief executive of banks in Illinois and Montana. He currently lives with his wife in Missoula, Montana, spending his time writing on personal finance, serving on two bank boards and hiking in the Rocky Mountains. Joe’s previous articles were Doing GoodTrue Wealth and Life as a Loan Shark.

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