“When I first came into this business, I thought that one of the most important things about helping a client with their portfolio was understanding a particular investment theory, asset class valuations, etc.. While that is important, what's really important is to help someone counter their own intuitions and emotions.”
That is what Mark Balasa from the private wealth firm Balasa Dinverno & Foltz had to say years ago. Read his advice based on practical experience.
People are financially and emotionally scarred. Often, it's on the loss side. It could be that they were too concentrated, or stayed in a particular stock too long. But what ends up happening is that they start to make decisions based upon their view of what a stock should be worth or anchoring.
For example, people come in and say, “my portfolio was at x number of dollars, and this is what I hold. We're not going to sell any of these until we get back to even because I'm not going to recognize a loss.”
While I understand the emotional pain of realizing a loss, it doesn't make great investment sense.
The extreme optimist or pessimist.
Market movements stoke emotional and behavioral issues.
A really strong bull run tends to stoke investors' overconfidence. On the flip side, when 2008 happened, people felt that it's never going to stop dropping. That’s what happened in the short brutal bear market of 2020 too. But the rally that followed made investors feel that the market will always go up.
Recency bias is the tendency to place too much emphasis on experiences that are freshest in your memory—even if they are not reliable.
This is why investors are challenged at evaluating their own risk tolerance. During a prolonged bull run, people view themselves as being comfortable with risk. And then, when market turbulence hits, they quickly realize that they don't like where they are. That leads investors to making the worst decisions at the worst time because they couldn’t take it anymore.
If you make short-term decisions based upon a little bit of volatility, and you go into an asset class that has five times the volatility, is that the right thing to do for the portfolio as a whole? Be very cautious and deliberate about what you are buying and putting into your portfolio. Many times it's very expensive or it's tax inefficient, it's illiquid or it's unproven or some combination.
Never forget that everything reverts to the mean over time. So the big long-term strategic approach is still the best approach as opposed to subjecting yourself to these short-term trends. Keep the portfolio strategically long-term focused as opposed to reacting to all the short-term influences.
When there is extreme pessimism, you may want to head for the exit. Cut yourself some slack. Instead, of selling in panic, go 5% or 10% into cash. It would not make a big difference to the total return in the portfolio--but psychologically, it is a huge release. They would feel like they did act proactively to preserve principal.
The rich widow.
We have a retired client; a widow with six children. She has saved a fair amount of money, just short of $1 million for herself over her lifetime. Her children have all had difficulty in the job market, so she feels like she has to help all of them.
She has kept her portfolio completely in fixed-income securities and refuses to tap into that money to live off of. Instead, she's living off social security and a very small pension, because she's absolutely paranoid about running out of money and not being able to leave the children anything.
The widow doesn't have anyone trustworthy to talk to or bounce ideas off.
If investors are isolated--and especially if they're in retirement--they may feel frozen in terms of making investment decisions for themselves, because they are so concerned about running out of money. If someone can give them a bigger view of what that money will mean to them, they can improve their lifestyles and still leave money for their children.
Take PIMCO, for example. PIMCO has an investment committee that puts together their best thoughts and their best ideas. But they have a shadow committee to provide a counter argument to what they are thinking. Despite all their experience and awareness, they want to be challenged, because you can get subject to group-think, and you can get subject to your own thoughts.
This is a great example of even the professionals in the business putting in place mechanisms and safeguards against getting too emotional, one way or the other, and that applies to individual investors as well.
DIY investors should have a sounding board. Your sounding board can be an investment buddy or a financial adviser.
Control what you can to offset what you can’t.
Minimize expenses.
Save more.
Work longer. Cultivate multiple sources of income.
Control your tax liability by harvesting losses.
On the debt side, to help insulate against turmoil, shorten the duration and look at credit quality.
Part of it is thinking about return expectations. Be realistic.
Be disciplined and detached. Don't check your portfolio daily. Don't dwell on it.
Stay away from too much noise. When you read too many articles, watch too many TV shows, listen to too many buddies at the barber shop, you get emotionally wound up one way or the other. Deliberately tune out.
The above information has been extracted from the conversations between Mark Balasa and Christine Benz in Avoid these behavioural landmines and The risk of playing it too safe
