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WHICH FINANCIAL dangers should we focus on? The possibilities seem pretty much endless. In fact, five years ago, I decided to make a list—and ended up offering readers 50 shades of risk.
Yet our notion of risk used to be far more circumscribed.
In the late 1980s, when I started writing about personal finance, insurance was considered important, but it wasn’t much discussed. Instead, the only risk that seemed to merit serious analysis was investment risk, and that could supposedly be captured by a single, objective measure: volatility.
This approach had intellectual appeal. By focusing on volatility, experts could sidestep a thorny issue—the fact that some investors were totally freaked out by investment price swings, while others remained unperturbed.
Part Four of Six
As data on historical market returns became more readily available, talk of short-term volatility was joined by discussion of longer-term risk. How likely was an investment to make money over one, five, 10 and 20 years? Once again, it was all about the numbers, with investors themselves strangely absent from the conversation.
The good news: Today’s discussions of risk are more nuanced, reflecting an awareness that the danger from misfortune is matched by the damage that can be done by our own behavior. Consider the typical stock-market cycle. Thanks to research by behavioral-finance experts, we now have a pretty good idea of how investors’ thinking changes along with the market.
What goes up. The goal of investing may be to buy low and sell high. But at market bottoms, when stocks might be available at 30% or 40% below their bull-market peak, we’re often frozen in place, fearful our own actions will make matters worse. Sins of commission and sins of omission can both cause financial pain, but sins of commission are much more likely to trigger pangs of regret.
As share prices tick higher, some of us will look to sell, as we recoup part or all of our losses. We’re anchored to the price we paid for our investments or to our portfolio’s highest value, and we’re anxious to sell before recent gains turn to losses once again. It’s the old “get even, then get out” syndrome.
Others, meanwhile, take the market’s short-term gain and extrapolate it into the future, prompting them to invest even more in stocks. Like the soothsayers of old, we study the market’s entrails, trying to divine the future by spotting patterns in today’s share-price movements. Our portfolio’s rising value makes us more confident not only about the rally, but also about our own investment acumen, as we attribute our gains to our own brilliance.
Among some investors, the rising market may even trigger the so-called house-money effect. What’s that? Like casino gamblers who get lucky early in the evening, bull markets can make us feel like we’re ahead of the game, prompting us to trade more and take additional risk.
What do we buy? Often, we’re drawn to the familiar, such as our employer’s shares or companies whose products we use. Alternatively, we might flock to soaring stocks and funds that are in the news or that others are currently raving about.
Taken together, such investments may leave us with a badly diversified portfolio, and yet familiarity and popularity can make these stocks feel like a safe bet. Buoyed by the enthusiasm of others, we end up with a far more aggressive portfolio than we owned at the bull market’s inception—setting us up for hefty losses when stocks turn lower.
All fall down. As share prices slide, we shrug off the setback, ignoring negative news and the market’s rich valuations. Instead, we seek validation in the words of Wall Street’s bullish pundits, taking courage from their upbeat market assessment.
But then stocks’ losses deepen, the pundits grow more equivocal and our confidence ebbs away. Initially, we’d expected the decline to reverse. Now, we start extrapolating the losses, wondering how much worse things will get.
At the market’s peak, we would boast to others about our high tolerance for risk and our hefty allocation to stocks. But that bravado evaporates along with our portfolio’s gains, and now we wish we owned a far less aggressive portfolio.
Enter loss aversion—our tendency to get far more pain from losses than pleasure from gains. Stung by our portfolio’s decline, some of us sell in a panic, because our investments are now underwater and we imagine things will get far worse. Alternatively, we might “double down” on our stocks, with an eye to speeding our portfolio’s recovery should the market rally.
But most of us simply sit tight. During the bull market, we took great pride in selling our winners, even if the result was hefty capital-gains taxes. But now that tax losses are readily available, we’re loath to take advantage, because we hate the idea of selling for less than we paid. Instead, we comfort ourselves by saying “they’re only paper losses.”
What about buying? Everything tells us not to: The news is relentlessly bad, the pundits declare that the bear-market bottom could be months away, and the market’s decline makes further losses seem inevitable. Stocks may be on sale, our wise neighbor declares that this is a great opportunity and we might even agree—but buying simply seems too risky.
Check out the three earlier articles in this six-part series: Money Grows up, Taking Center Stage and Mind Over Money.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.
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My 2 cents. First and foremost, no one can predict the future. We do know there is another bear market on the horizon; we simply don’t know when. With that knowledge I’ve decided it is more important to position my portfolio for that inevitable bear, rather than worrying about it or attempting to avoid it. I will participate in it, that is guaranteed. I do hold some cash, which reduces my returns. However, I can deploy at opportune times and yes, I do realize I’ll never time the market and deploy at the bottom.
There are compromises to be made.
Education helps to manage the emotions. When I was a young draftsman the firm that employed me had many individuals who invested. During one nasty bear market, I recall a discussion the substance of which was “It doesn’t matter what I buy, it all goes down.” I concluded that investing was gambling, and with little knowledge it certainly would be for me.
As time went on, I became aware of mutual funds and later ETFs. I became aware of diversification and stock allocation and index investing. I also became aware that over long periods of time the S&P showed gains and dividends were desireable.
I also became aware of simple tools for portfolio analysis, such as the Morningstar X-Ray tool and Firecalc.com.
However, some bear markets are worse than others and it is dangerous for one’s financial health to invest in vaporware. At one point during the Dot-Com bust, my retirement portfolio had been reduced to about $8,600 with permanent losses.
Time, it has been said can heal wounds and so it is with my investments. I took what I learned and weathered the 2007-8 banking fiasco. Because I’m a net saver, I had funds to invest carefully and I did. I also invested in individual stocks because that is a way to exceed the returns of the S&P 500. However, the ballast for my little sailing ship was, and remains mutual funds and/or index ETFs with a sprinkling of sector funds. Overall, my portfolio is comprised of about 27 holdings and because I’m retired is largely on autopilot.
As for time, it does matter. A bear may last for 5 years and so too for a boom. An investment horizon of 20+ years worked for me, and I buy with the intention of holding it for at least 5-10 years. Many of my current holdings were acquired 17 years ago.