A Love/Hate Relationship

I love to make money. It’s certainly not the most important thing in my life, but as early as I can remember, I have had a fascination with earning and saving money. What’s even better is when the money gets to work and my account balance grows with no additional effort on my part. On the flip side, I hate to lose money. Or more accurately stated, I get a pit in my stomach when my account balances fall for several days (or weeks) in a row. When the stock market hits a rough patch, I feel pretty lousy. Especially because I know that our clients are experiencing the same “gut-check” that I am going through.

Academics have studied this love/hate relationship for years and the general consensus is that people experience a more intense feeling (and have a longer memory) of investment pain than of investment joy. In other words, a 20% drop in your investment portfolio has a greater impact on your psyche than a 20% gain.

So, why do any of us accept risk when it comes to investing? It becomes more difficult to remember the reasons for risk when times are difficult, but I take risk because I have to. My financial goals require that my savings appreciate over time. More importantly, my savings must grow at a rate greater than inflation. Therefore, without the benefit of risk, the probability of achieving my long-term goals would be very low.

Of course, there is no guarantee that the assumption of risk will produce the expected reward. In fact, it would be a safe bet to assume that a “risky” portfolio will underperform a “risk-free” portfolio during multiple calendar years of any given 10-year time period. Since 1926, there has not been a single 10-year period of time where the S&P 500 index did not experience one or more calendar year losses.

[A “risky” portfolio is any portfolio where one’s principal is subject to loss. While we acknowledge that nothing is completely free from risk, an example of a “risk-free” portfolio would be one that holds federally-insured CDs and/or U.S. Treasury bills.]

With the benefit of hindsight, it is easy to spot those pivotal changes in investor sentiment. Without hindsight, the task becomes a crap shoot. During the 1980s and 1990s, the investment mantra was to “buy the dips”, meaning that one should invest more money every time the stock market fell (because it always seemed to recover quickly). While it is easy to see the wisdom of having followed that advice today, anyone who had significant money invested during the crash of 1987 (or at the start of the first Gulf War), will tell you that those were serious gut-check moments and many people bailed on buying the dip.

From March 2000 to March 2003, a “risk-free” portfolio would have handily beaten a broadly diversified equity portfolio. From 2003 to 2007, one could have invested in almost any “risky” asset (stocks, bonds, gold, oil, real estate) and trounced the “risk-free” return. From September 2007 to March 2009, CDs and Treasury bills were once again the place to be.

You know the rest of the story–just when it seemed like the whole world was going to crash in on itself, stocks established a bottom in 2009 and proceeded to double in value before the most recent decline. No bell or alarm sounded at any of these inflection points. To my knowledge, not a single person has claimed to have perfectly timed all of these aforementioned shifts in sentiment and value. Why is it then that some people continue to believe they have the ability to time the entry into, and exit out of, “risky” and “risk-free” assets?

We can’t control risk–it is an unknown. We can do our best to manage it, but ultimately, the events of tomorrow are beyond our control. Therefore, instead of focusing on volatility as a bad thing, let’s look at it from a different perspective and see how it can help us. For example, a diversified portfolio of small company stocks behaves somewhat differently to changes in the economy than a diversified portfolio of large company stocks. There are many reasons for this, but the key observation is that stock prices tend to be more volatile for small companies than for large companies. Over time, disciplined investors have been rewarded for accepting this additional risk. Specifically, small U.S. stocks produced an annual average return of 11.7% over the fifty years ending 12/31/11. Large U.S. stocks delivered 9.3% over the same time period. For every $1,000 invested fifty years ago, the small company portfolio would have generated an extra $3,273 over and above the large company portfolio. This is just one example of how you can take advantage of the average investor’s aversion to risk.

Personally, one of the most difficult things for me as an advisor is seeing people who allow emotions to sabotage their investment plan. They are able to save and they are able to plan, but they don’t have the ability to remain committed to their plan in the face of negative news and falling valuations. They lose faith and often end up making an investment decision based on emotion instead of analytical thought. Regrettably, it only takes one bad decision to put your entire financial future in jeopardy.

For comparison, consider the value of your home. Most people spend a lot of time thinking about how much to pay for their house and how much to ask for the house when it is time to sell. The price of your house on all the days between those two events really doesn’t matter if your plan is to stay there for an extended period of time. Would you live your life differently if the value of your house was updated like a stock and available for sale on a daily basis? Would you sell your home if it dropped in value suddenly and someone on CNBC said that you should consider a change? The media (and often our friends) can have a powerful influence over our decisions. Intelligent investors recognize this and guard against making emotional decisions.

I know how hard it can be to go against the innate desire to avoid pain. When markets are in turmoil, remember to focus on your long-term goals. Review your Investment Plan and Investment Policy Statement. The relationship between risk and return is one of love and hate–there will be conflict. Use logic to battle emotion! Make sure you have sufficient emergency reserves in “risk-free” assets. Just knowing that you have an adequate short-term buffer is often all one needs in order to remain committed to the long-term plan.