IF WE WANTED to design a portfolio that appeals to our worst investment instincts, we might couple a savings account with lottery tickets. Some governments have even issued bonds with just these characteristics.
What’s the attraction? The savings account ensures that part of our portfolio never loses value, while the lottery tickets let us dream of riches in return for a relatively small investment.
This year, we’ve seen the lottery-ticket mentality writ large, as investors take fliers on meme stocks, nonfungible tokens and cryptocurrencies in hopes of hitting the jackpot. For instance, earlier this year, dogecoin could be bought for under a penny—less than the price of a lottery ticket. With a little daydreaming available for so little money, maybe it’s no surprise that dogecoin is up more than 6,000% in 2021, even after this month’s shellacking.
But while this year’s frenzy over fringe investments has hogged the headlines, let’s not forget our other behavioral impulse: our strong aversion to losses. This instinct may not lead to short-term financial disaster. But it can wreak havoc over the long haul. What’s so wrong with trying to avoid losses? It can result in three crucial mistakes.
1. Confusing stability with safety. If we own stocks and stock funds, the market tells us every day what they’re worth. Let’s face it: Most of us would rather not know, which helps explain why we’re drawn to investments where the price seems stable, even if that stability is an illusion.
For instance, many investors prefer individual bonds to bond funds, because they know precisely what those bonds will be worth on the day they mature. What about the fact that this maturity value may be far lower because of inflation, or that we may get some quite different value if we sell at any time before maturity, or that we’re banking on a single issuer rather than getting the broad diversification offered by a fund? It seems many folks happily overlook these drawbacks in return for the illusion of safety.
Similarly, many investors are drawn to the certainty offered by equity-indexed annuities and tax-deferred fixed annuities, even though these insurance products require locking up money for many years and investors could face steep penalties if they exit early. A lack of daily price information is, I suspect, also part of the appeal—as it is for both real estate and venture capital investments. Until we go to sell, we don’t really know what a piece of real estate or a private business is worth—and that allows us to imagine the price is marching steadily higher, with no need for us to lose sleep.
2. Chasing yield. In the quest for psychological comfort, some investors focus not on price, but income. If a bond, stock or other investment kicks off a generous and predictable stream of interest or dividends, we can imagine it’s super-safe. Sometimes, that may be the case.
But often, that regular income disguises an otherwise dicey investment. Take General Electric, once considered to be the archetypal widows-and-orphans stock. In 2009, GE qualified as a “dividend aristocrat” because it had increased its dividend for 32 consecutive years. That, however, was also the year it slashed its dividend amid the financial crisis. Today, the stock pays just a penny a quarter, down from a high of 31 cents.
Over my career, I’ve seen yield-chasing investors torpedoed in countless investments, everything from option-income funds to short-term multi-market income funds to high-yield junk bonds to bank loan funds. The regular income gave the illusion of safety. But eventually, the price of these investments told another story, prompting many investors to panic and sell.
3. Forgetting taxes and inflation. While some purportedly conservative investments turn out to be riskier than investors expect, there are many truly safe investments, such as savings accounts, short-term Treasury bonds, bank certificates of deposit and savings bonds. Investors shouldn’t ever wake up one morning and discover these investments are worth far less than they imagined.
But they might feel that way 10 or 20 years down the road. With even high-yield online savings accounts paying just 0.5%, investors are looking at falling behind inflation by two percentage points a year over the next five years, based on current inflation expectations. Once taxes are figured in, things would look even more grim.
If you have money you’ll need to spend soon, I see no sensible alternative to holding cash investments and suffering this loss of purchasing power. What if you have a longer time horizon? To outpace the twin threats of inflation and taxes, you need to take greater risk—but you need to do so sensibly. Forget dogecoin and digital cat images. Instead, think total market index funds.