How Investors Lose Money
May 15, 2012When it comes to investing, the proverbial crystal ball is cloudy as to what tomorrow may bring, but it’s pretty clear when it comes to looking at what doesn’t work. The story tends to become even clearer during times of higher short-term volatility; that is, investors who don’t ride the tide of market ups and downs tend to lose out. Take for example Chart 1. Over the last 20 years, money has flowed into equities (stock mutual funds in this example) at an increasing level as the stock market has been going up. Then, once the stock market is already on a downward trend, money starts flowing out of equities. What’s happening here? Bad investor behavior. Buying high to sell low; that’s a recipe for losing money and is opposite of the fundamental way to make money over time.
The first step to limiting investment losses is recognizing your own behaviors and emotions. If you tend to hit the panic button because you can’t stomach seeing your stocks go down, even sharply, for a few months, you could be the biggest roadblock to making money for yourself. Conversely, if you get really excited after a strong Wall Street rally and want to get a bigger piece of the action, suddenly pressing the “buy” button and repeating this pattern over and over can hurt you as well.
There are ways to overcome human emotions when it comes to investing. One is to have a strategy, stick to it and make certain modifications over time that are likely not “all in” or “all out” moves. Take a look at Chart 2, which shows how various asset classes have performed over the last 20 years, compared to how the average investor has done. The average investor has barely kept pace with inflation, which is not surprising if you reflect on the pattern seen in Chart 1: Buying high to sell low and then continually repeating this pattern. To help avoid becoming a run-of-the-mill investor, delegating to a professional who can separate investment emotions from fundamentals may be a wise idea. A good advisor will care about your money, what it needs to do for you, and understand you need to keep a steady pace — not sprint — in order to successfully reach the finish line.
Next, have enough cash on the sidelines to give yourself the peace of mind that you can weather downturns. For many retired Brightworth clients, we typically recommend having one to three years of your portfolio withdrawal needs in cash, CDs, money market funds, etc. For clients who are still working and accumulating money, they likely need one year or less of cash reserves. On this same note, have enough bonds in your portfolio to preserve capital, provide income and reduce the overall swings in your account. Keep in mind that stocks can provide returns to outpace inflation and taxes over time, but how much you personally need in stocks to achieve your financial goals should be carefully considered. Running some numbers and having a strategy can help answer this important question for you. At Brightworth we use a variety of methods to analyze this for our clients, including our Wealth Assurance ReportTM.
Finally, turn off the news or get rid of the financial apps on your smart phone. Market sentiment changes from hour to hour, but fundamental values of companies (stocks) do not; so your portfolio shouldn’t be adjusted that frequently either. Knowing yourself and having confidence in your investment strategy can help make the investing experience a good one; one where you end up being better than average.
