Investing Basics Part 2: The Emotional Side

Egg Faces - Investing Basics - Emotional Side
A typical investing experience

I fell while running this past week. Not lightly. 

The sidewalks in my neighborhood are not even and though I have learned how to navigate them, I missed a slightly raised portion. I tripped, fell, and skidded across the concrete. In the process, I took a few chunks out of my hands, knees, and shoulder. Thankfully, my hands protected my face from going headfirst into the sidewalk. Unfortunately, I had taken off my running gloves 30 seconds before my fall. Now, my hands are bandaged and healing. 

During the pandemic, I made a habit of running first thing in the morning to get my heart rate up and relieve stress. As winter arrives, the mornings are darker. 

In preparation, I purchased a new headlamp and a bright yellow reflective vest. I wanted to see and be visible to others. I wanted to be safe. 

Despite my best safety efforts, I already had a run-in with a family of raccoons who decided to run across my path right as I was running. After the raccoons hissed and scampered away, I continued on my run unharmed. That was a few weeks ago. 

After my latest debacle, running is looking more dangerous. But, it’s not. There are risks that come with it; however, the benefits outweigh the risks. I can do everything possible to minimize the risks, but I cannot eliminate one hundred percent of the risks. If I want the benefits of running, I have to accept them as part of the process.

This idea is also applicable to investing. To earn good long-term returns, you willingly need to accept the ups and downs in the market. It’s not a matter of if the market will drop, but when

As with running, knowing your goals, designing a plan, and writing it down increases the odds of success. 

Last week, I covered how investing should be boring, how to access investments, and market history. 

This week, I will cover more of the behavioral side of investing. 

Investing Basics: Create a Plan

What is the money for? Why are you investing? What’s the purpose?

The best investors connect the investment to a purpose. It could be a home purchase in 5 years, college in 18, or retirement in 40. Either way, you should know the goal because then you know how best to invest the money and when you reach your goal. 

For example, if you need a down payment for a home purchase in five years, how you invest that money and the risk you are willing to tolerate is far different from an investment strategy focused on retiring in 40 years. The down payment should be invested conservatively. Retirement money should be invested more aggressively. 

Instead of thinking of the plan and keeping it in your head, you should write it down. In fact, an investment policy statement (IPS) can be a helpful document to decide how to invest money. You can see a sample.

It will include information such as current assets, return goals, time horizon, objectives, types of investments, how you will monitor the portfolio, and rebalancing. Since the market can be scary during declines, having it written down means you only need to revisit and follow your investment policy statement. You don’t need to create anything new when emotions are running high. 

Without it written down, you’ll likely be more tempted to make random decisions during the worst possible times. 

For example, if you are investing for retirement and the market declines 30%, you can consult your investment policy statement to decide what to do. Perhaps it says to rebalance and buy stocks when there is a decline of 20% or more or when your stocks are five percentage points below their normal allocation percentage. 

If you were targeting 50% stocks and your IPS said to rebalance when your stocks reached 45%, you now have an easy rule to follow. Instead of making excuses not to buy because of politics, unemployment numbers, scary headlines, home prices declining, or the speculation of war, you only need to pay attention to two numbers – your normal stock allocation target and where it is today. If you reach 45% stocks, you can sell bonds or other more conservative assets to buy stocks to rebalance back to 50%. Simplify and make it easy on yourself. 

Adding on to last week, investing should not only be boring, but it should also be fairly unemotional. Don’t get too attached to investments, regardless of whether they are doing well or poorly. 

I cannot stress enough how important it is to create a written plan with the rules you need to follow. You will experience difficult investing times, and a plan is what helps keep you from making foolish decisions. 

Avoid Market Timing

Market chart

Have you seen the confident-sounding expert on television or in a thought-provoking article speculate about how the market will do XYZ in the next year? 

It’s garbage. 

Nobody knows which way the stock market is headed. Sadly, very few people go back and review previous forecasts to show how accurate (or more precisely, how inaccurate) they were. 

In fact, some of the brightest, well-educated economists in the world are bad at forecasting whether a recession will even happen.

If they cannot correctly predict whether a recession is going to happen, how is any person going to successfully forecast the stock market? There are too many variables and too many forces at work. Even the latest pandemic is a perfect example. 

Let’s say you had a leg up because a magic genie told you a worldwide pandemic was going to happen. How would you change your investing strategy? Perhaps you sell everything and go to cash. You see the market declined by about 30% and you think, ‘Wow, that was a smart decision.’ 

Now what? 

Unemployment numbers are terrible, people are dying, and the economy is closing. Surely, you stay in cash. 

Oops. The Federal Reserve lowers interest rates to 0%. The US government pumps trillions into the economy and the stock market begins to recover very quickly. The stock market feels disconnected from the economy. It still feels awful. You wait in cash. There will be a second wave and things will get worse. There is a second wave, but the market continues to go up. 

In this example, you knew what was going to happen, something nobody knows, and yet, you still got it wrong. 

The problem is that even if you knew what was going to happen, you have no idea how other people will react. You have large participants in the market, such as The Federal Reserve, and you have everyday investors acting. Those individual decisions cause prices to move as a collective. In the short term, it’s noisy. In the long-term, it’s clearer. If you play in the noise, you are likely to get lost and make mistakes. 

I read about an increasing number of individual investors day trading markets more now. One of the scariest experiences investing is when someone confuses luck with skill. 

For example, let’s say 300 million people flipped a coin on day one. About 150 million people will flip heads. They continue flipping for a total of 15 days. After the 15th day, there will still be about 9,000 people who flipped heads 15 days in a row. Even after the 25th day, about nine people will remain. 

Was it skill? Of course not! 

And yet, being lucky, the people who flipped heads 15 days in a row could probably write a book and create a course about how to flip heads fifteen times in a row and people would buy it. The people who flipped heads 25 days in a row could start a hedge fund to profit off flipping heads. The same thing happens in the investing world.

If I bet enough times on a stock, the market direction, or anything else, eventually I will get something right. Everybody will ignore the previous inaccurate forecasts and focus on the one that was right. 

Don’t confuse luck with skill. Research paper after research paper demonstrates investors should avoid market timing. 

Low costs

You should aim to keep your costs low; however, this is where I see many investors go wrong. You can buy index funds that are free. They have a 0% expense ratio. 

However, they may not be as diversified, target the allocation you want, or they may increase your tax burden. I always like to remember that if something is free, I am the product. 

Some markets are more expensive to access. For example, you might have an S&P 500 fund that costs 0.03% and an emerging market fund that costs 0.67%. Is the emerging market fund expensive and awful?

No, not necessarily. 

If the average expense ratio of similar emerging market funds is 1.32%, it is very inexpensive. It also provides diversification. In some areas, it is okay to pay more money for a fund if it enhances the portfolio. 

While costs are important, they should be done on an apples-to-apples comparison. You would not compare a Ford truck to a Ferrari sports car. They serve different purposes. 

Discuss With Others, But Don’t Confuse for Advice

Unless someone is intimately familiar with your situation and an expert in finances, you probably should ignore them – including me. 

There is a reason I say this blog is for informational purposes only. I know nothing about you. I cannot give you any advice. Imagine taking medical advice from a random person. How well would that work? 

I am not saying to ignore others entirely. In fact, I love it when people start money conversations. We need more of them. 

What people do not need is an acquaintance, friend, or family member selectively sharing hot stock tips and how they “just made a ton of money by investing in XYZ stock.” People come away thinking, ‘Wow, it’s easy. If they can do it, I can do it.’

When people say they did well in the stock market, what you should be asking is to see their investment statements for the past few decades. Nobody likes sharing their failures, but they happen. When people only talk about their wins, it skews the narrative. 

It’s like social media. If you only ever see the vacation photos, perfect family portraits, and celebratory moments in life, you think that is all that exists. 

What about the other moments? The experiences of losing luggage, bribing kids to take a photo, and experiencing the death of a loved one. 

If people curate their investing experience, be skeptical, ask questions, and don’t blindly follow what they are doing. 

Personal finance is personal. I might tolerate a 50% decline in the stock market. You might only tolerate a 25% decline. I might have no emergency fund and cannot invest in a family business. You might be financially independent with extra to spare for a family business. I might be in a low tax bracket. You might be in a high tax bracket. 

Each person is different. This is why you create an investment plan unique to you. 

Ignore the Financial Media

Financial newspaper

It is not all bad, but enough of it is bad that it is easier to say ignore it all. If there is poison in your food, you do not eat around it. You toss the plate. That’s what I am doing with the financial media. It’s too hard to separate the few good ones from the numerous bad ones. 

Financial media exists to sell ads. They need you to tune in as frequently as possible to earn those ad dollars. To do that, they create scary headlines, bring on “experts” to explain why the market moved a certain direction and flash red and green numbers as if you were in Las Vegas gambling. 

Accept You Will Make Mistakes

Every investor makes mistakes. Accept it will happen and learn from it.

At least once in life, most people will make an investment because they fear missing out. During the Tech Bubble, this happened frequently. People tend to chase returns of individual stocks, sectors, or anything else that is new and shiny. Chasing returns usually does not end well, but it is a humbling lesson when it occurs. 

At some point, you likely will let your emotions get the better of you. For many, it comes in the form of selling at a low, claiming “This time is different.” You cannot control markets, but you can control how you react to them. Hopefully, if you make this mistake, the impact is minimal. 

I also wouldn’t be surprised if you forget that patience overcomes many problems in life. You may start investing and have two years of negative returns, possibly longer. That doesn’t mean you are doomed or you are doing anything wrong. That also does not necessarily mean you should change your investments. Sometimes that is the unfortunate timing of when you start investing. If you follow your plan and the process is sound, you likely will be okay. 

Summary – Final Thoughts

You can be the best-prepared investor in the world and your investment decisions can still feel like a disaster at times. It is normal. 

Because it is normal, you need to create a plan in advance. It should clearly spell out the rules for how you manage money. Much like an evacuation plan, you don’t want to think during times of distress – you want to act based on a prepared plan. 

Most investors are well served by avoiding market timing, keeping investments costs low while remaining diversified, discussing finances with others while still being skeptical, and accepting that as much as they prepare, they are likely to still make mistakes. 

If you have an investment story where you learned a lesson you want to share, please email me. I would love to hear it!

Disclaimer: This article is for general information and educational purposes only and should not be considered investment, financial, legal, or tax advice. It is not a recommendation for purchase or sale of any security or investment advisory services. Please consult your own legal, financial, and other professionals to determine what may be appropriate for you. Opinions expressed are as of the date of publication, and such opinions are subject to change. Click for Full Disclaimer

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