Six charts to help you understand how the markets really work and help you avoid four high risk investing mistakes.
In a previous post I talked about risk in general:
A risk is an unknown negative outcome with a probability of occurrence and level of impact
and how you can manage it:
Avoid it, Accept it, Transfer it or Mitigate it.
In this post I‘m going to talk about risk in investing. But not from the usual perspective. Often when the subject is market risks, the discussion is focused on the behavior of a particular investment, or class of investments. How stocks are riskier than bonds, because their values fluctuate so much more. Or how “junk” bonds are riskier than “investment grade” bonds, because the bond issuer has a higher chance of defaulting. Yes, these are unknowns, and the outcome from a limited perspective is bad: the investor could lose part (or all) of their investment.
From a personal financial planning perspective, the ultimate risk is much more general: not having enough money to meet your future needs.
From this point of view, the biggest risks look different. You are saving some of your hard earned cash, and you’d like it to grow to fund activities in the future, like retirement, or sending the kids to college, or the downpayment on a house. You take that money and invest it in the markets, buying stocks and bonds, with the expectation that your money will grow.
So what could go wrong?
Here are the 4 highest risk mistakes I’ve seen individual investors make. And they all have one thing in common: a misperception of the real risks of investing, or not investing, in the market.
Mistake #1: Panicking and selling when the market drops
The stock and bond markets go up more than they go down, and they can go steadily up for a number of years in a row, which can lead people to expect that the markets always go up. This is an example of recency bias, a cognitive tendency where our brains overemphasize recent events compared to historical occurrences when predicting the future. (1)
If you don’t know how the market has behaved in the past, or you subscribe to the “this time is different” story that is always being told by someone, it can be very surprising how far and how fast the markets can drop. Between October 2007 and March 2009, the S&P 500, a proxy for the US stock market, dropped over 50%. And if that same recency bias convinces someone their investments are going to keep going down, they can panic and choose to sell, often right before things turn around.
What’s the risk? The market drops enough that you feel you need to sell out.
What are the consequences? You lock in the losses that were only there on paper, and lose the opportunity to make money when the market rebounds.
How to deal with this risk so you don’t make this mistake? Mitigate it.
Pay attention to the two components of personal risk I discussed in the last post:
Your basic risk tolerance, or risk personality, which is generally stable throughout your lifetime
Your perception of the risk in a particular situation, which is affected by your experiences
Understand your own innate tolerance for risk, but most importantly, study historical market performance, or work with a financial professional, to be sure you don’t have an incorrect perception of the volatility of the markets. Set up a portfolio that has the right mixture of higher and lower volatility investments so there are less likely to be surprises large enough to cause you to panic.
Why is this important? The stock market has historically been the best place to beat inflation over the long term (2). But you have to stay invested to let it work for you. If you sell when your investments have dropped, you lock in your losses, and then have to decide when to get back into the market. And having just been spooked enough by a market drop that you sold out, you are unlikely to get back in fast enough to catch the rebound that is sure to come. As the graphic above makes clear, missing just a few of the best days of market performance can make a big difference to your final outcome.
This is the same reason why avoiding the next mistake is also important.
Mistake #2: Selling when you think the market will drop
Some investors spend a great deal of time watching the markets to see when it might be time to get out. Fearful of losing their money, they feel the need to watch for signs of upcoming troubles. And no matter what the actual current economic picture is or what is happening in the markets, there are always plenty of media articles and talking heads predicting disaster to come.
If someone’s fear in another area adds to their worry about their investments, it can become too much for them to take. It could be something they think they see in the economy, or a fear of “globalization” of the world economies, or even a reaction to the most recent presidential election here in the US. Their investments may not have dropped, but they are very sure a loss is coming. Most of the time they are wrong, and having gotten out, they miss future gains when the markets rise again.
Other investors see patterns in market gyrations and think they can make more money by selling when the markets are going to go down, and getting back in when they are going to go up. Unfortunately, individual investors who attempt to time the markets are generally not successful (3, 4).
Reliably predicting near-term market behavior is next to impossible. Even the more level heads, economists and financial professionals who take an objective, analytical approach, do not have a good record predicting near-term market returns (5). There are simply too many factors involved, from unseen events like a global pandemic, to investor emotions, and the overall complexity of our economic system.
What’s the risk? Your perception of the likelihood of a drop in the market increases to the point that you feel the need to sell out.
What are the consequences? You lose the opportunity to make money in the market at all.
How to deal with this risk so you don’t make this mistake? Avoid it.
The stock and bond markets go up and down, but when and how much is unpredictable. Accept this fact, and don’t try to time the markets. Take a long term perspective, invest in a way that matches your personal risk profile so you can sleep at night, and don’t spend too much time checking on your investments. If you find this difficult, doing an overall financial plan with a financial professional could help you put things in perspective and make it easier to stay invested when you get worried.
Mistake #3: Being too aggressive for your savings time horizon
When you choose to invest, you typically have a goal for the money. It may be retirement, or college funding for your children, or it might be the downpayment on a house, or leaving a legacy to your heirs. The goal will usually have both a time frame, and an amount you want to have at that time. But if things go wrong, how bad will the negative consequences be?
Risk Capacity is the level of risk you can take on and still handle the potential negative outcome
Someone may have a high tolerance for risk, investing in an aggressive portfolio of small company stocks, or putting all their money into cryptocurrencies, and sleeping just fine at night as their portfolio gyrates. And if they really don’t need the money to meet an essential financial goal at a specific time, then they may also have sufficient risk capacity to invest that way. However people often get focused on the potential returns of aggressive investments (real or imaginary) and lose sight of the consequences of the downside risks. They may put their emergency fund into the stock market and then find that it has dropped 30% right when their home needs a new roof. They don’t actually have the capacity to handle the risk they have taken on; no matter their personal tolerance for risk.
What’s the risk? The investments you have chosen to meet a particular goal are down when you need the money.
What are the consequences? You are forced to sell low and may not have enough to meet your needs.
How to deal with this risk so you don’t make this mistake? Avoid it.
Any money that you will need for sure at a particular time frame in the future should be invested to match that time horizon. Take into account how much a particular type of investment has historically gone down and how long it took to recover. Very broadly:
Cash and equivalents like money market funds, high yield savings accounts, or CDs, are very unlikely to drop in value, and deposits at banks are guaranteed by the Federal government up to certain limits.
Bonds, aka fixed income investments, do fluctuate in value when held in a portfolio or through mutual funds, but less than stocks.
Stocks, aka equities, will fluctuate the most and take the longest time to recover from a large drop.
I generally recommend that my clients keep cash for needs 1-2 years in the future in high yield savings accounts, money market funds, or CDs; invest in bonds for needs 3-7 years out; and only put money they can let ride for at least 8-10 years in the stock market.
Why is this important? If your goal is truly a need, and not just a nice-to-have you can postpone, you want the money to be there when it’s time to use it. The more aggressive the investment, i.e. the more volatile it could be, the longer it needs to be left alone to have a good chance of growing for you.
Mistake #4: Being too conservative to meet your savings goals
The flip side of Mistake #3 is being too nervous about investing in the markets to use them to significantly improve your financial situation. While someone who invests too aggressively for their time horizon may not have enough money when they need it, the same is also true for someone who invests too conservatively and doesn’t save enough to make up for the lack of potential return. It won’t be because their investments have dropped in value, it will be because they never grew enough in the first place.
As I talked about above, the three broad types of investments, cash and equivalents, bonds, and stocks, have different levels of volatility over different time frames. But the potential return of an investment is generally related to its perceived riskiness, which is usually associated with its level of volatility. To take on a riskier investment, there should be some incentive in additional potential return to keep the investor hanging in through the volatility.
Again broadly, historically over the long term, cash has returned the least, bonds have returned a bit more, and stocks have ultimately provided the highest level of returns, when allowed the time to grow. If you tamp down on the volatility of your investments by sticking with “safer” options, you will also reduce the potential for growth in your portfolio. Play it too safe, and you may not even beat inflation, meaning your money is losing its purchasing power over time.
What’s the risk? Your risk tolerance causes you to invest so conservatively that your money doesn’t grow enough to meet your goals, perhaps not even keeping pace with inflation.
What are the consequences? You don’t have enough money to meet your needs in the future.
How to deal with this risk so you don’t make this mistake? Mitigate it or accept it.
If you can mitigate the lower potential for growth in a conservative portfolio by saving more, then you may still be able to meet your needs in the future. Perhaps you are currently making much more than you actually need to live on, so you can save a large amount towards your retirement while you are working, invest conservatively, and still have enough to maintain a simple lifestyle when you stop working.
Or, you may simply accept the risk that inflation reduces the purchasing power of your savings and plan to adjust your savings goal in the future. Perhaps you can pay for in-state college for your kids, instead of out-of-state. However, accepting a risk should be done with awareness of the potential consequences, not by just sticking your head in the sand and hoping it doesn’t happen.
Successful investing: letting the markets work to meet your goals
One of the biggest challenges in investing is finding the right amount of risk to take on so you can avoid these common investing mistakes many people will make. Put a plan in place that balances your ability to take on risk and sleep at night, with your need for growth to meet your goals, and then stick with it!
References:
1 - Investopedia, Recency (Availability) Bias: What it is, How it Works, https://www.investopedia.com/recency-availability-bias-5206686, accessed 07/23/2023
2 - CNBC, Why High Inflation Makes Investing in the Stock Market a Smart Move, https://www.cnbc.com/2022/03/22/why-high-inflation-makes-investing-in-the-stock-market-a-smart-move-.html, accessed 08/13/23
3 - Morningstar, Bad Timing Cost Investors One Fifth Their Funds Returns, https://www.morningstar.com/funds/bad-timing-cost-investors-one-fifth-their-funds-returns, accessed 08/13/23
4 - CNBC, Why Investors Should Never Try to Time the Stock Market, https://www.cnbc.com/2021/03/24/this-chart-shows-why-investors-should-never-try-to-time-the-stock-market.html, accessed 08/13/23
5 - Rochester Business Journal, The Dubious Value of Market Forecasts, https://rbj.net/2023/08/10/the-dubious-value-of-market-forecasts-the-informed-investor/, accessed 08/13/23