Behaving Badly

Jonathan Clements

OTHERS MIGHT BE hoping to add to their wealth by picking the next hot stock. But here at HumbleDollar, we’re much more concerned about subtraction.

The goal: Keep more of whatever the financial markets deliver by minimizing investment costs and avoiding unnecessarily large tax bills. This is a reason to favor index funds. But even if we index, we need to be alert to another threat—that posed by the person in the mirror.

Two recent studies highlight the risk of self-inflicted investment wounds. “When do investors freak out?” asks the title of a new academic study. The paper looks at instances where a household’s stock holdings drop 90% or more in a month, of which at least 50% is due to trading.

Such “freak outs” tend to occur during sharp market declines, and they’re more common among those who are male, over age 45, married or have dependents. Freak outs are also more common among those who say they have excellent investment experience or knowledge.

For these investors, the big shift out of stocks tends to protect them in the short term. But they’re often too slow getting back into the stock market, so they miss out on significant gains. It’s become a cliché, but it’s worth repeating: What matters isn’t timing the market, but time in the market. The stock market’s big gains usually go to those who sit quietly with diversified stock portfolios for decades and decades.

That lesson was reinforced by a recent study from Morningstar. The Chicago investment research firm found that fund investors earned 7.7% a year on the average dollar they invested in mutual funds and exchange-traded funds over the 10 years through year-end 2020. That was 1.7 percentage points less than the total return of the funds themselves.

What explains this shortfall? It all comes down to bad timing, with investors tending to invest more heavily in a fund before it suffers a period of relatively weak returns. But some funds triggered worse behavior than others. The biggest performance gaps occurred among more specialized funds, namely those that focus on single industry sectors and on alternative investments. For such funds, the shortfall was around four percentage points a year.

By contrast, the annual performance gap with general taxable bond funds and U.S. stock funds was 1.1 and 1.2 percentage points, respectively, while the gap with asset allocation funds—think target-date retirement funds—was just 0.7 percentage point.

How do we avoid buying and selling at the wrong time? Morningstar offers some sensible advice, such as sticking with broadly diversified funds, avoiding funds that are more specialized or more volatile, and putting our saving and investment programs on autopilot. To that list, I’d add three other pointers:

Play dumb. One of the smartest things we can do is regularly remind ourselves of our ignorance. If we find ourselves making risky investment bets or unloading a huge chunk of our stock portfolio, we’re doing so because we think we know something about future returns. Such “knowledge” is often poisonous to performance.

Play money. Many investors simply can’t resist meddling with their portfolio. To limit the potential damage, consider dividing your portfolio into “play money” and “long-term growth money.” Allow yourself to buy riskier investments and make market bets with perhaps 5% or 10% of your portfolio. Meanwhile, dedicate the rest of your investment dollars to a collection of index funds, such as the classic three-fund portfolio, and declare these investments untouchable.

Play it safe. To your “play money” and “growth money,” consider adding a third bucket: “safe money.” With this sleeve of your portfolio, the goal is to hold enough cash and short-term bonds so you don’t freak out.

How much should you hold? It’s easy enough to calculate your necessary cash holdings based on your likely portfolio withdrawals over the next five years and the sum you want for emergencies. But that’s the rational number.

What you need to figure out is the emotional number—the sum you need to set aside to keep yourself calm, so you don’t make big changes to your long-term growth money at times of market turmoil. How do you come up with that number? You’ll need to take a long, hard look in the mirror.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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