Op-ed: Methods to keep in management and keep away from emotional funding choices
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We saw the story of two markets in 2020.
The market experienced a brief, steep, and frightening free fall. Still, it turned quickly and stocks ended the year near all-time highs.
This unique experience had a huge impact on the psyche of investors and, consequently, the way they handled their money. Some investors were too traumatized to put money into the markets. Others reacted with aggressive day-to-day business and made hasty investment decisions.
Neither of these behaviors is beneficial to long-term financial success. Assessing both responses and incorporating an appropriate process-oriented approach to managing your investments is the best way to avoid similar missteps in 2021.
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When the market fell, the economic situation looked grim and unemployment reached levels not seen since the Great Depression. I remember talking to investors when the market was falling and I suggested putting some money on the work. Some of the responses I received fell broadly on the subject of "I don't want to catch a falling knife", "Let's wait for things to settle down", or "Let me think about it and get back to you."
All of these reactions were essentially just one way for investors to procrastinate. I advised against this approach, but they were understandably marked by the free fall they had just experienced.
Over time, this postponement turned into "investor indolence". These people were too comfortable sitting in cash and they had no strategy for getting back into the market. As a result, they missed the market recovery and lost purchasing power due to inflation. Both of these consequences could affect the ability of some of these investors to achieve their financial goals in the long run.
The Federal Reserve, Treasury Department, and Congress acted quickly to ease monetary policy and pass the CARES bill, and small business loans under the paycheck protection program helped prop up the economy.
This spurred the market to recover and helped investors regain some confidence.
Over time, however, that confidence turned to confidence, and millions decided to try their hand at day trading.
The most popular stocks also showed some of the best performance. As a result, many investors continued to cling to their favorite names and ignore basic investment principles like proper diversification.
The investment excitement contributed to the appreciation of some cryptocurrencies, a record number of IPOs and the increasing popularity of Special Purpose Acquisition Companies (SPACs). These factors, coupled with the meteoric rise in the market, created the euphoria that led some investors to be cautious. Many of these day traders were rewarded for their carelessness with stunning year-end returns.
It is especially important to remember during times of exuberance that markets move in cycles. A period of profitability for a group of stocks can be followed by a period of underperformance. This can be clearly seen in the entire history of the market. The S&P 500 has seen a decade of oversized returns. However, investors are quick to forget that the index was unchanged from 2000 to 2010.
The opposite is true for emerging market stocks. They have had a lackluster average return of roughly 3% per year for the past 10 years, after hitting the stellar 37% average annual returns from the past decade.
The sectors also move cyclically. Technology stocks are having a wonderful run right now. However, it took NASDAQ 15 years to peak again after falling 70% when the dot-com bubble burst. Years of underperformance are a hallmark of the market. You are not an anomaly. Investors need to plan accordingly.
How do investors overcome these behaviors?
Build a process-oriented investment approach
One means of overcoming the investor psyche and the above two behaviors is the same. It requires creating a process-oriented approach to your investment. This has four key components.
First, create a statement on the investment policy. With an IPS, investors can clearly define their financial goals and other guidelines for how they want to manage their money. A properly established IPS will guide both the bear and bull markets and keep investors from losing sight of what they are trying to achieve with their assets.
Diversification isn't as exciting as trading the hot stocks of the day. However, this minimizes the chance of a catastrophic loss, which can help keep investors on track to meet their goals. To use a baseball analogy, you don't have to complete home runs to win the game. It's far better to focus on getting base hits on a regular basis and avoiding a strike.
Periodic balancing is also critical. The realignment will adjust the portfolio weights as the investments fluctuate in value. By setting pre-determined weighting thresholds for each investment or a regular schedule for when to rebalance, rather than trying to determine an optimal time to buy or reduce your own inventory, this process can be automatic without involving emotions.
Familiarize yourself with averaging the dollar cost. Money is automatically added to your portfolio on a regular basis. This removes the temptation to time the market and alleviates the worry of investing at the wrong time. Regardless of what happens in the market, money will continue to be added at regular intervals so that your own investments can continue to increase in the long term.