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Misleading Ourselves

Adam M. Grossman

INVESTING CAN BE maddening. Stocks that look like they’re going up can end up falling, while investments that look like they’re headed for the dustbin can suddenly bounce back. This leaves investors in a difficult position—because the right thing to do often feels wrong.

Investing requires us, quite often, to act contrary to our own intuition. Here are four examples.

1. Don’t equate price with quality. When consumers walk into a retail store, do they prefer the products that are on sale or do they head straight for the full-price items? All things being equal, most people prefer to pay less rather than more. But when it comes to the stock market, intuition often leads us in the opposite direction.

In our minds, price is associated with quality, so we end up being attracted to investments that are more expensive, not less. On top of that, because it’s natural to expect trends to continue, we assume that if the price of an item has been going up, it’ll continue rising. On the other hand, if a stock has been falling, we assume that there must be something wrong with it and we expect it to keep falling.

This logic is, of course, backwards. Like any other prospective purchase, we should be more interested in buying an investment when its price is lower. I’ll acknowledge that this is easier said than done. If an investment has been beaten up—and especially if you’ve incurred a loss on it—it’s understandable to want to distance yourself from it. Even though the price might be attractive, it’s difficult to buy more of an investment at a time like that. It just doesn’t feel right, and for good reason. One definition of insanity is doing the same thing over and over, expecting a different result. It can seem insane to put more money into an investment that’s declined in price, expecting it to suddenly behave differently.

As consumers, we’ve been trained to think this way—to see price as an indicator of quality—so it’s a deeply ingrained intuition. There’s a famous story, in fact, about the eyeglass company Warby Parker. The founders—a group of business school students—believed they could run a profitable business selling glasses online for $49. When they consulted their marketing professor, however, he argued that this was a bad idea. Consumers, he said, wouldn’t trust the quality of a product that was too inexpensive. Instead, he suggested they set the price much higher. Warby Parker is now a very successful business selling glasses for $95.

How can you get over the psychological hurdle of buying something that looks unattractive only because of its low price? The simple solution, in my view, is regular rebalancing. Suppose you start with an asset allocation of 50% stocks and 50% bonds. If the stock market drops so your allocation to stocks falls to 45%, you would buy more stocks—enough to get back to 50%. It still may not be easy to buy stocks when they’re depressed, but I find this framework can make the decision easier.

2. Don’t look back. When I think about the stock market, I often think of Charles Dickens’s line: “It was the best of times, it was the worst of times.” This describes the stock market perfectly. Virtually every year, some categories of stocks deliver strong performance while others lag. The challenge is that these categories change from year to year. There’s no such thing as permanent outperformance.

Between June 2001 and June 2007, for example, European stocks climbed 120%, while the U.S. stock market gained just 46%. Since then, things have reversed. Through the end of March, domestic stocks have gained 296%, while European stocks are up just 45%.

We’ve seen similar reversals in highflying tech stocks. In the depths of the pandemic, stocks like Shopify, Zoom and Peloton were all home runs. But this year, Peloton is down 26%, Zoom 36% and Shopify 50%.

Even in the quieter world of bonds, investment categories frequently trade places. Two years ago, municipal bonds—traditionally a very stable asset class—lost value quickly in response to worries about municipal finances when the economy shut down. High-yield bonds also lost value at that time. Both categories subsequently bounced back, more or less in unison. This year, though, they’ve again lost value in response to rising interest rates. Meanwhile, the big winner recently has been something else entirely: inflation-protected bonds, which for years were uninteresting because inflation was so low. Suddenly, they’re everyone’s favorite bond.

How should investors navigate this constantly shifting landscape of winners and losers? Again, it helps to have a framework. Continuing with the above example, if your portfolio has a 50% allocation to bonds, you might designate further targets within that 50% to specific categories of bonds, such as 20% to municipal bonds, 20% to standard Treasury bonds and 10% to inflation-protected Treasury bonds. Then try hard to stick to these allocations through good years and bad, recognizing that the three categories will inevitably trade off over time.

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When I was a kid, I remember going to a horse race with a friend’s family. My friend won $2 on one of his bets and immediately said, “I wish I’d bet more.” It’s the same with investing. At any given time, every investor will wish they’d owned more of a particular category. But that’s the price investors pay for the benefits of diversification. When you own a diversified portfolio, you’re accepting that each year you’ll own some winners and some losers. But you can’t know in advance which will be which. That’s why I suggest choosing a sensible mix of investments—and then not looking back.

3. Don’t put the tax cart before the investment horse. Many investors, I’ve noticed, prefer to sell only investments that have losses, or perhaps just small gains, so they minimize their tax bill. On the surface, this makes sense. But this is another area of investing that’s counterintuitive.

From an investment perspective, the right thing to do is to sell investments that have done well. That’s because they’re the ones that may now be overvalued. At the very least, they’re the ones that may be overweight relative to your asset allocation targets. Problem is, from a tax perspective, these are the investments you’d least like to sell.

How can you manage this inherent conflict? In my experience, it doesn’t need to be an either-or decision. If you want to sell some investments, I generally recommend selling a mix. Sell some with big gains, some with small gains and some with losses. That, in my view, is the way to balance both the investment and tax objectives.

4. Don’t worry about IRA distributions. In years when the stock market is down, investors often fret about taking required minimum distributions from their retirement accounts. They hate the idea of selling when the market is low. Here’s the reality: While IRA distributions need to come out in cash, there’s no reason you can’t immediately reinvest the distributed funds. In your taxable account, you can always buy back the investments you just sold in your IRA.

Taking an IRA distribution when the market is down actually results in a more favorable outcome than if you’d taken the distribution when the market was higher. For the same number of dollars—and thus the same tax bill—you’ll end up with more shares of a given investment outside your IRA. This will provide greater appreciation potential in your taxable account, which is advantageous because the lower capital-gains tax rate will now apply.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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ishabaka
ishabaka
2 months ago

“Taking an IRA distribution when the market is down actually results in a more favorable outcome than if you’d taken the distribution when the market was higher. For the same number of dollars—and thus the same tax bill—you’ll end up with more shares of a given investment outside your IRA. This will provide greater appreciation potential in your taxable account, which is advantageous because the lower capital-gains tax rate will now apply.”

This doesn’t make sense to me. Say I bought 10 shares of X at $10 per share in my IRA = $100. Shares go down 50% and I sell for $50 and withdraw the funds. No tax deduction for loss since the shares were in my IRA, and I pay ordinary income tax rates leaving me, say, $30. Now I take that $30 and buy shares of X in my taxable accounts. Since X is now $5 per share I wind up with 6 shares. I wind up with FEWER shares, not MORE.

David Powell
David Powell
2 months ago

Are there other metrics in which you might ground good index price discipline beyond trailing P/E, CAPE, and P/B? PEG?

graphex
graphex
2 months ago

4b…if your RMD is big enough that you are investing some of it into your taxable accounts then you should also be doing some Roth conversions. Doing this when stock prices are down results in you shifting a higher percentage of your taxable IRA assets to be forever nontaxable. And depending on where your IRA assets are, you can also be opportunistic on when you do Roth conversions. Meaning (at least at Fidelity) you can enter this type of transfer after market closes and take advantage of when you think the market has overreacted.

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