The Other Side of Irrationality

Irrational is too strong a word but it’s one we read about in (behavioral) finance quite a bit. Investors that panic sell in bad times or that expect unsustainable high returns forever in good times are not irrational. In fact, we can see how they come to their decisions. There’s a difference between irrational and uninformed.

Some pundits like to point out that we are in the midst of one of the longest bull markets in stocks in history. If you start counting the years from the market bottom of March of ’09, then it has indeed been a long bull market. Some say that you should actually start the bull market from the point where it recovered from the losses of the great recession. The previous high in the S&P was November of ’08 and it took until March ’12 to get back to that level. Either way, this bull market longevity has caused two types of reaction in many investors. We’ve addressed those investors who fear the market must collapse any day now, the investor who’s scared to put more money to work at this time. But what about those that believe they should receive double digit returns from stocks going forward because that’s what they grown accustomed to? We encountered this behavior in the late ‘90’s and to some extent again in ’07.

Here’s the irony: the S&P 500 has returned 10% (exactly!) on average from 1926-2016.  However it has never returned 10% in any given year. The closest is came was 1993 when the return was 10.1%. The range over this time period has been between -43.3% (1931) and 54% (1933). If we look to the post war era, the range has been from -37% (2008) to 52.6% (1954). That’s how you get to a 10% annualized rate of return. This positive rate of return must exist for Capitalism to succeed. Our economic system isn’t perfect but it has thrown off this average positive return for as long as we have reliable records and some cite more than 200 hundred years of evidence. The key to capturing this return is patience…discipline. Investors must accept the volatility inherent in returns in order to capture the return itself.

Here are two simple concepts to remember when market volatility (up OR down) start to concern you:

1.       Don’t become overly wrought when you think markets are going down for what feels like forever. In fact, that’s probably the time they will turn around. The definition of a market bottom is when pessimism is at its peak. No one is calling to invest at this time; panic reigns. And conversely, don’t take on too much risk when markets are posting record highs year after year. The definition of a market top is when optimism is at its peak and no one is telling you to get out at this time in the market cycle; euphoria reigns.

2.       Diversify!! The above returns of the S&P 500 represent large company stocks in America. This is but one asset class out of many to which investors should be exposed. Although there has been a tremendous amount of research conducted on diversification, the concept is simple; don’t put all of your eggs in one basket. Invest in low cost, tax efficient vehicles in markets that have a positive expected return. Don’t speculate…invest.    

Here are some other tips to help you achieve the positive rate of return the market throws off: stop watching financial TV news shows; stop listening to financial radio shows; stop looking at your account value on line more than a couple of times a year.

·       Focus on financial planning to make sure you are utilizing of all the tax advantages available to you in estate, college, and retirement planning.

·       Make sure you are properly insured (life, health, elder care, home, auto).

·       Consult professionals on health coverage and social security benefits before you retire.

·       And lastly make sure your investments reflect the appropriate amount of risk for your circumstances and time horizon.

Most investors we see focus entirely on their investments which are but one aspect of a sound financial plan. Don’t make this mistake. Plan your future and revisit that plan annually or bi-annually.