How to Avoid the Emotional Investing Trap

How to Escape the Emotional Investing Trap

A prospective client reached out to us late last December in a panic, reporting that his investment advisor lost him $1 million, roughly 15% of his investment portfolio. This person, who had just sold the business he had spent the last 30 years growing, was devastated and convinced his world was going to end.

I know situations like this can be heartbreaking. During the depths of the financial crisis, we encountered some client situations that were similar in terms of the acute mental and physical anguish they triggered. In this case, his portfolio drop was similar to the U.S. stock market decline in the fourth quarter 2018.

Given the fourth quarter drawdown and subsequent recovery this year, this is a good time to examine investment losses. As we do this, I’d like to point out that the word “loss” is often used casually and imperfectly in the investment world. Investors, advisors, the media and others often say loss to describe a decline in value, which, yes, may be a significant decline.

True losses can be avoided

A true loss, on the other hand, is a permanent impairment of capital. You make an investment, the value of the investment goes down and you either sell it to hold cash or it never recovers to the amount of capital you invested. Clearly true investment losses can be catastrophic and may prevent you from achieving the goals you’ve set out for yourself.

Fortunately, a limited number of situations actually lead to investment losses. Here are a few of the most common, and ways to avoid them:

1. A single investment crashes and burns. Unfortunately, concentrated investments are typically more susceptible to ruin, which can result in the permanent reduction or elimination of invested capital. This is the most common situation in which investment losses occur, and they happen all the time for different reasons (think Enron, pets.com, Blockbuster). Most investors protect against this type of loss by spreading their investment dollars across different types of investments to diversify their risk and reduce the likelihood of loss.

2. Moving to a more defensive investment strategy during periods of steep market declines. Long-term investing goes hand-in-hand with periodic short and short-ish term periods of market declines. Regardless of the speed and severity of the declines, no one likes to see their portfolio fall in value, and there’s been a lot of behavioral finance studies that confirm we humans hate our losses more than we love our gains.

Pervasive negative media and our personal situations (especially when we’re living off the portfolio like the prospective client I mentioned earlier) can exacerbate our fears and cause us to panic. These conditions cause some investors, who can’t stomach seeing their portfolio take a nose dive, to sell a portion of or the entire portfolio and put the proceeds in a less risky investment, like cash, to “stop the bleeding.” While this type of emotional reaction is understandable, it’s also dangerous. Investors in this category often stay in the less risky investments too long and miss out on the opportunity to participate in the investment’s recovery when it occurs.

The best protection for this type of loss is to work with an objective third-party advisor who can help guide you to an appropriate risk-adjusted investment strategy for your personal situation, and who can hold your hand to prevent you from jumping ship when the investment seas get rough.

3. Over-leveraging the portfolio. When severe market declines occur, some of the most aggressive investors are forced to sell investments because they overleveraged their portfolio with margin. They borrowed money via a margin loan and invested it in the portfolio, and now the brokerage firm requires the sale of investments to reduce the outstanding loan. Best practice is to use leverage judiciously, so you cushion the net portfolio against short-term volatility. We usually advise to lever no more than 20% to 25% of the investments you’re borrowing against. And be mindful of the investment environment in which you’re leveraging the portfolio. For example, use leverage when investment valuations are low, not high like they are today.

4. Fraud. An investor hires a fraudulent investment manager who swindles their money. (Ever heard of Bernie Madoff?). Careful due diligence, skepticism (Did the manager really make money during periods of steep market declines?), using a separate investment custodian when making publicly traded investments, avoiding investment herd mentality, and limiting the amount of private investments with a single manager all can help prevent losses from this risk.

You can recover

If you can steer clear of the above situations, there’s a very high likelihood declines in your portfolio will recover over a period of months, quarters and, in some cases, years (making it feel like you’ve suffered a permanent loss, but you haven’t). As practical as this is, I know from experience that this reality offers little comfort when investment markets are down more than 10%. When the things that are really important to us are at stake — like the nest eggs we’ve worked so hard to accumulate — that can be stressful, worrisome and distracting.

Here are a few strategies for getting through severe periods of portfolio declines:

1. Respect your investment time horizon before declines occur. Make sure your investment strategy is aligned to when you’ll need the money you’re investing. If the investment horizon for a high-priority purchase or expense is short (less than seven years), don’t invest it in a strategy that has a lot of stock market exposure and could experience significant near-term declines. If your investment horizon is longer than seven years (keep in mind that retirement often lasts 15 or more years), prepare yourself in advance for periods of major corrections because they are going to happen. If you realize at the outset that your investment strategy has a high likelihood of declining by $20,000, $200,000, $2 million or more at the outset, that will ease the shock when big declines occur.

2. Be mindful of relative investment performance. Compare the performance of your portfolio to a suitable benchmark. If your portfolio is declining during tough times at the same general pace as the benchmark, like our prospective client’s was, there’s likely no reason to be overly concerned. After all, a falling tide lowers all boats.

3. Find a trustworthy advisor. Work with a financial advisor who knows you, understands the purpose of your investment portfolio, and can be an objective party to get you through periods of market stress. Importantly, if you’re feeling fear or concern, call the advisor and talk about it. Find out if you can take any actions on things you can control (unlike the stock market) that might help you get through the period of market distress.

4. Clear your mind. Go for a walk, listen to birds chirp, take in an amazing view. At the risk of sounding too Northern Californian, spending time in the natural world can help us clear our minds and focus on what really matters.

Investment markets naturally ebb and flow over time. From a historical perspective, the U.S. stock market has experienced relatively little volatility over the last 10 years or so. We don’t know when the next period of significant declines will occur, but this time is as good as any to start preparing yourself emotionally and avoid letting yourself think a major decline in the portfolio is a permanent loss. Chances are, if you stick with your well-thought-out investment strategy, it won’t be.

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