The enemy within: As investors, we are programmed to be the single greatest threat to achieving our investment goals

“The investor’s chief problem and even his worst enemy, is likely to be himself” – Benjamin Graham, economist and author of The Intelligent Investor (published 1949).

While we would emphasize that a hierarchy of factors contribute to skilled investment decisions, such as assessing risk attitude and capacity, understanding necessary cash flow and tax implications, and developing and rebalancing an appropriate asset class and investment manager mix, Graham’s quote on the heels of the Great Depression resonates just as profoundly today as it did then. Those complex and technical investment management components can be rendered meaningless if one’s investment behavior is not adequately addressed. As illustrated above, investors’ “gut” reactions to the headline du jour throughout a market cycle (which typically lasts 5+ years from peak to trough and back to its peak) can swing wildly.

Even if one’s financial objectives remain constant, we are programmed to make knee-jerk decisions based on gloomy headlines which can jeopardize our wealth in the long run. The temptation to time the markets (a speculative attempt to avoid market downside or capture upside) is a natural impulse, as most individuals experience the pain of an investment loss compared to the joy of an equivalent gain on a 2:1 basis (as reported in A Survey of Behavioral Finance, conducted by the National Bureau of Economic Research). But contrary to our natural inclinations, time in the market (long-term time horizon to support your goals) has proven to be a far more beneficial strategy than timing the market (succumbing to our irrational reactions, most commonly greed and fear). I would like to emphasize that we are programmed to act irrationally, and that it is not a character defect!

These are the most common investment behavior pitfalls to be aware of (and shut down!)

Self-attribution/asset class performance chasing – Investors may attribute positive returns to factors they can control (such as emphasizing security selection) over more impactful performance drivers like asset allocation (appropriate balance between major asset classes such as equities, fixed income and alternative investments). Particularly in a bull market (we are currently in the longest bull U.S. equity market in history), overconfident investors may be tempted to chase returns and over-budget their total portfolio risk to outperforming asset classes.

Fear of loss – As previously mentioned, most investors weigh losses twice as heavily as gains. Answer this question for yourself, would you rather risk losing $20 with $10 of potential upside, or completely avoid the chance of losing $20 and incur no change? We certainly acknowledge the importance of wealth preservation and establishing a prudent asset allocation strategy to help minimize sensitivity to market drawdowns; however, engaging in risk avoidance behavior due to news headlines (which are often unrelated to long-term market and economic fundamentals, and instead focus on immediate emotional engagement) can be a major contributor to long-term underperformance.

Disposition effect – The disposition effect was coined by two economists, Hersh Shefrin and Meir Statman, to describe the propensity of investors to hold onto assets that are losing value for too long and to sell assets which have appreciated too quickly. Such behavior is particularly pronounced following a period of market volatility. We would emphasize that periodically rebalancing one’s portfolio asset allocation in line with their targets (reducing outperformers and adding to underperformers) as well as reviewing available tax loss harvesting opportunities and dollar-cost averaging (committing to investing a portion of cash at scheduled intervals) helps to reduce the anxiety commonly felt following a market downturn.

What happens if I allow my emotions to rule my investment decision-making?

Material reduction in long-term performance – According to the DALBAR Quantitative Analysis of Investor Behavior Report, the average equity fund investor over the past 20 years underperformed the S&P 500 Index (a widely-used benchmark for U.S. large cap equities) by approximately -2% per year. Over the same time frame, the average fixed income investor underperformed the Barclays Aggregate Bond Index (popular gauge for U.S. taxable bonds) by roughly -4% per year. The report cited irrational attempts to time the market as well as individual fund manager performance as key drivers for the negative results. The average investor retains equity mutual fund managers for approximately 3.6 years and fixed income mutual fund managers for 3.1 years, which is a fraction of the typical market cycle length (5+ years).

As well as significant reduction in short-term performance – Attempting to time the market should be viewed as a three-part parlay wager: correctly predicting when the market will begin to descend, when it will bottom out and which market classes will outperform on the upturn. Conversely, by staying invested, an investor in U.S. large cap equities over the past 20 years through the end of 2018 would have gained +5.6% per year, compared to +2.0% (by missing out only on the market’s 10 best days), -0.3% (missing out on the 20 best days) and -4.2% (missing out on the 40 best days). The market’s worst and best days tend to be clustered, which makes missing out on a handful of those days a common occurrence for those attempting to guess when trends will begin and end. And missing those important days can have a severe effect on one’s wealth in the long-run.

You will likely miss out on a portion of the market recovery, which can be short-lived – On average, for the year following the end of a bear market, U.S. large cap equities have provided a return in excess of +38%. Ten years following a bear market, the recovery has historically been +14% per year. Equities tend to appreciate over the long-term (positive in 29 of the past 39 years), even accounting for average intra-year declines of nearly -14%. Since the 1930s, U.S. large cap equities have endured, on average, a -10% pullback at least once per year and -5% pullbacks around 3 times per year. Simply put, it is normal for markets to pullback and subsequently recover over longer time frames. While it may feel painful to endure the market declines, it’s much worse to miss out on the recoveries. In a study conducted by the University of Michigan (Stock Market Extremes and Portfolio Performance), 95% of the market’s gains were concentrated in 1% of all trading days (merely 3 trading  days per year) over a 30 year window.

Being self-aware of our unique investment behavior pitfalls and actively suppressing our “gut” reactions is certainly a demanding task. But the facts bear out that over time, succumbing to your emotions during periods of market volatility can have a profound impact on your wealth. Even the most high-flying investment portfolio can be derailed if we allow irrational impulses to direct our behavior. Rather, we advocate to our clients stoicism in the face of volatility and adherence to an investment strategy which supports their long-term goals.

If you have any questions about your portfolio, please reach out to your wealth counselor or a member of our investment team – we would be happy to take a look at your specific situation.

About the Author

Chase Conti, CFP®, CAIA provides due diligence on investment managers, works with financial advisors to construct investment strategies and integrated asset allocations, and oversees all trading activity.

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