October 12, 2015

After 25 years in the investment world, I have learned much about stocks, bonds, CD’s, mutual funds, etc. It has taken me many years to truly understand the real key to successful investment strategies: never underestimate the damage that can be done by decisions made under emotional duress.

When asked what they expect from their investments, clients have a simple answer, “Make lots of money”. Or, “Don’t lose any of my money”. This seems pretty straightforward, but is it? What is “lots of money”? If your quarterly statement shows a smaller account value than the previous quarter, have you lost money? The answer may not be as straightforward as you may think.

Many investors have a preconceived notion of what they expect from their investment returns: 3%, 5%, 8%, 12%, or delusional. But how do we really measure success when analyzing returns in a portfolio? First of all, what is your time horizon? Short term volatility can skew returns and the way people view them. During the late nineties, people were euphoric about the incredible amount of money they were making in a short period of time. That euphoria quickly changed to despair with the arrival of the technology crash and the broader market deterioration that occurred in 2001-2002. This pattern continued into the 2000’s as the housing bubble created an even greater “market crash” in 2008-2009.

So let’s break down the various emotional stages that occur during market cycles. The economic climate and iterations of the stock market may cause people to react irrationally. When the market is in a nosedive, there are various emotional stages they may experience. First they are surprised when their account value starts to go down. Then nervousness sets in, as the losses continue. Then they become worried about their money and their future. Finally, they may feel panic stricken. At this point, we see “capitulation”, people are defeated. Somewhere between the stages of panic stricken and defeated, investors may run for the hills and sell everything. This investor behavior led Warren Buffet to utter one of my favorite quotes, “The stock market is the only place where when things go on sale, no one wants to buy”.

The next emotion that occurs is being paralyzed by fear. “I will never again invest in the stock market”. Then something interesting occurs. While sitting in cash, or CD’s, anything that is “safe”, things start to change. Stocks start to recover. People (although not invested) may feel cautious and start to consider “taking another dive into the pool”. Then the market starts to go up more and they become hopeful. Now, as they are watching CNBC, they hear nothing but good news and see continued upward movement in the market. Next, they feel encouraged, positive, and even begin to become confident. Now the market is riding high and retirees are sitting in Denny’s talking about the latest hot stock. Wow, now they are thrilled and becoming euphoric. Somewhere between thrilled and euphoric, our fearless investor jumps back in, at the height of the market, only to be traumatized one more time. Various studies have shown that this emotional roller coaster leads many investors to experience inferior returns over the long haul. Yes, they have unwittingly become that dreaded investor who buys high and sells low.

Earlier, I talked about expectations of portfolio returns. Let’s first examine a logical way to approach these expectations. Rates of return are relative to the overall economic environment, namely “inflation”. An 8% return in 2015, with inflation at less than 2%, may be labeled excellent. But how did an 8% return look in April 1980, when inflation was 14.76%? Now let’s start to put a rational spin on expectations and market returns. In my view, a successful result when investing, is getting a rate of return that keeps up with inflation, and meets the client’s individual needs. What does that mean, and what does this have to do with emotions and investing? Hang around and we’ll dig deeper.

Once inflation has been matched in a portfolio, the excess over inflation becomes the target rate of return. What percentage over inflation, based upon spending and savings patterns, do you need to meet long-term goals for accumulation and cash flow needs upon retirement. After this is determined, the target rate of return and expectation of returns may be viewed in a different light. If a 55 year old couple needs 3 to 3 1/2% over inflation to meet their goals for the next 30+ years, then I would say that’s a reasonable and rationale expectation. Then, an investment strategy and portfolio design may be established to accomplish the goal and keep volatility within the constraints of this couple’s ability to handle the iterations of the stock market. The determination of needed rates of return may include goals such as college funding, purchasing a vacation home, or leaving a legacy to children or charity.

When approaching investing in this manner, clients more easily understand what their goals are, which can lead to expectations that are reasonable. Continuing education about market volatility and keeping a long-term perspective, may help keep emotions in check. Remember, losses in your portfolio occur when you sell that investment and spend the money. Otherwise, it is a “paper loss”, which probably won’t impact your long-term financial goals. We cannot control what China is doing, the value of the dollar, and certainly what the fed may be up to in regards to interest rates. But, with a high degree of confidence, we can construct a portfolio to help clients achieve their long-term financial goals.

Once a clear direction has been laid out, I have found that people deal much better with the “craziness” that can sometimes be the stock market. You are better able to handle the inevitable emotions that are part of the universe of investing. Understanding how this process works, and keeping a long-term perspective, leads to rational decisions, reasonable expectations, and most important, sleeping soundly through the night.

Yours in service-

Brent H. Soloway, ChFC® Financial Planner

Any opinions are those of Brent Soloway and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Holding stocks for the long-term does not insure a profitable outcome. Investing in stocks always involves risk, including the possibility of losing one’s entire investment.