Taking a timeout

Meagan Dow, CFA^®, CFP^®
Senior Strategist, Client Needs Research

Too often, our emotions can be the biggest barrier to our investment success. In these situations, it’s important to take a timeout and remember why you’re investing: your retirement, your child’s education, your legacy. A short-term market decline doesn’t change these long-term goals. You can learn more in our Webinar, "Investing and Emotions".

The result of emotional investing

Why is it so important to be on your best investing behavior? Poor investing behavior can lead to insufficient diversification among different types of assets, chasing market performance, and moving into and out of the markets (often at the wrong time). Not surprisingly, the typical result of these behaviors is poor long-term performance, which could lead to the biggest risk of all: not reaching your long-term financial goals.

The consequences may be even more dramatic than you think. For example, the average annual return for a balanced portfolio (65% equity and 35% fixed income) over the past 30 years was 8.1%. However, the average U.S. investor received a 5.2% return because of investing behavior. But with the power of compounding, the difference wasn’t simply 2.9% a year; it could have been about $600,000 over that 30-year time frame.

When you feel your emotions getting the better of you, take a timeout and work with your financial advisor to review your goals before making what could be an emotional investing decision. Your portfolio and your future self will thank you.

Investing behavior: Heading to (or staying on) the sidelines

Whether it’s the economy, the national deficit or market fluctuations, there will always be headlines that can distract you from focusing on your long-term goals. Trying to avoid potential stock market declines may lead to the following bad behaviors.

Trying to time the market

Some investors may try to sell to avoid additional declines. But to time the market successfully, you must get two decisions right: When to get out, and when to get back in. Getting one right is difficult; getting two right is nearly impossible.

Holding too much in cash

Others may hold too much in cash, thinking they are avoiding risk. However, this could increase the risk of not having enough growth in their portfolios to meet their goals or offset inflation. Not staying fully invested or jumping into and out of the stock market can seriously affect performance, since many investors often get out after declines and then miss the positive moves. The effects of missing the best days can be substantial, as shown in the following chart.

How to avoid this behavior

Avoid the headlines

When negative events occur, the media can appear to add to the drama by using strong headlines or highlighting historical information about previous issues. At times, this includes emphasizing poor market performance in ways that can set off alarm bells among investors. However, the BusinessWeek cover shown here preceded one of the strongest equity markets in history.

Focus on your long-term goals and not the ever-changing headlines, and remember we’ve successfully navigated tough periods before.

Know yourself

Talk with your financial advisor to better understand your attitude toward risk and how you may react to specific events. By knowing in advance how you may react, you can be better prepared when
the inevitable short-term declines occur.

Understand the risks of not investing

The biggest risk you may face is not reaching your long-term goals. Assuming a modest 3% inflation rate, prices will double during a normal 25-year retirement period. Look to growth investments to help keep pace with inflation.*

Investing behavior: Chasing performance

When the media hype the latest hot investment or highlight dramatic declines in the market, we are often tempted to chase the winners and sell the losers. But this emotional response can lead to buying investments at market peaks and selling them at market lows — a recipe for underperformance.

How to avoid this behavior

Stay diversified

Instead of trying to find the next hot investment and chasing performance, it’s important to spread your investments across assets and remain diversified. This helps ensure you have different types of assets and investments — each of which may perform differently at different times. By chasing the leading asset class, portfolios may not only end up with a lower return but may also become much less diversified than we would recommend. While diversification cannot guarantee a profit or protect against loss, it can help smooth out market ups and downs, potentially providing a better long-term experience.

The chart shows $25,000 invested each year into either a 65% stocks/35% bonds portfolio or the previous year’s best-performing asset class (winners).

Investing behavior: Focusing on the short term

It’s important to focus on the long term, but day-to-day fluctuations can often get in the way, causing us to:

Fixate on a certain point in time

Depending on the vantage point, the same situation may look very different. For example, some investors sold in 2008 because their portfolios had fallen from an all-time high value, even though their performance may still have been on track and well above where they initially began.

Base decisions on how the information is framed

Decisions can be influenced by how a situation is presented. For example, assuming a Dow Jones Industrial Average value of 30,000, one can say, “Dow plummets 300 points,” or, “Dow declines 1%.” Both describe the same situation, but the first sounds worse. With the Dow exceeding 30,000, we should expect larger point moves, but how the media present market movements can lead investors to make emotional short-term decisions.

It all depends on your perspective, as highlighted below. The graphs show the same performance but a different perspective. The top graph shows monthly fluctuations in the S&P 500, and the bottom shows its long-term performance — illustrating why it’s important to keep a long-term focus.

Value of $100 invested in the S&P 500 Total Return Index from 1926 to 2023

How to avoid this behavior

Set realistic expectations and focus on your goals

The stock market averages a 10% correction every year. There have been 33 bear markets and 33 recoveries since 1928. Over a 25-year retirement, you could experience eight to nine bear markets on average. So, market declines, while unpleasant, are in fact normal. Measure your performance as progress toward your long-term goals rather than in day-to-day fluctuations.

Understand the purpose of your investments

In retirement, some investments provide you with income today. Others are there to help provide income many years from now. Each serves a crucial role in ensuring your money lasts as long as you need it.