Sometimes Doing Nothing Can Hurt You
Having been actively discussing investment portfolios with many individuals recently, some very common themes keep cropping up, so much so that I had to write this article. If you are struggling with what to do in the midst (aftermath?? beginning??) of the current worldwide stock market correction then rest assured you are definitely not alone. Today we will explore a few common sense ways to get your portfolio back on track.
Your Pain is Shared
It is often said that misery loves company. This is certainly true when it comes to recent stock market events. If you utilize one of the majority of financial advisors, or traditional investment or banking institutions, your portfolio today most likely has a high concentration of public stocks and bonds. You are also most likely concentrated in Canadian stocks or mutual funds. As Canada is such a resource-based economy, with so much reliance on the energy sector, your investments have probably taken the full brunt of the recent downswing. You are looking for answers but your advisor repeats the same mantra of “stay the course, everything will recover, it always does”. You take solace in conversations with neighbours and friends that everyone is suffering together. Even though you may have been through this before, it is certainly gut-wrentching, and you start asking yourself if there might be a better way than repeating the same emotional stock market roller coaster every few years.
Emotions vs. Logic
Human nature dictates that we become extremely polarized when faced with stressful situations such as severe stock market downturns. We might go into a shell, turn off the business news, ignore the investment statements, and essentially hide from the markets. Even though logic tells us that something is simply not right about the way we are invested, we satisfy the ego, by reminding ourself that things will turn out okay if we simply ignore it and do nothing. On the other hand, we may capitulate, and give into the pressure. We may decide to sell everything, keep our investments in cash, and wait it out. Or we may decide to completely change our investment strategy, moving from 100% public investments to 100% private, or from managed to Do-It-Yourself, or any other change of an extreme nature, essentially jumping from the frying pan into the fire. The degree of stock market correction severity usually prompts an equal degree of reaction, and we must realize that this premise is flawed because both responses are driven by our emotions. We satisfy our ego by “at least doing something”, even if that something goes against logic, and will actually hurt us financially in the long run. Looking in the mirror, and simply realizing that these changes we are contemplating are being driven by our emotions and potentially hurting us, is the first step to getting back on track.
Once we can step away from the veil caused by this cloud of emotion, we can start using logic to drive investment decisions. This first step is the most difficult because it involves self-examination, but it is the most valuable, because without that realization we simply fall into the same pattern of behaviour over and over, of boom and bust, high highs and low lows, and emotional decisions. Logic-based decisions are sometimes much more subtle and less exciting but ultimately much more rewarding financially. With a clear head we can realize that perhaps our Canadian oil stocks aren’t necessarily bad, we are simply too concentrated in that area, and need to cut back, to lower portfolio volatility. Or maybe we simply have too much, as a percentage of our portfolio overall, invested in stocks. The best thing to do many times is not the extreme thing to do. The problem to overcome is that making logical decisions does not necessarily reward the pleasure centres of our brain. There is simply much less excitement involved, much of the time, in doing the right thing. My challenge to you is to put this article aside for a moment, reflect on investment decisions you have been making or avoiding, and answer the question “Are my decisions emotional or logical?”
The following are some simple logic-based steps that you may decide to take when you are truly ready:
Step #1- Create or Update Your Retirement Plan
It never ceases to amaze me the number of investors I speak with that have not had a retirement plan completed for them. It doesn’t need to be overly complicated. You should essentially be able to understand your sources of retirement income vs needs throughout your lifetime. Recently I spoke with an investor who has been dealing with their current advisor for more than 15 years. He mentioned developing a close friendship with the advisor to the point where their children grew up together and are friends as well. The broker has been managing stocks, bonds, and mutual funds for this family for years. And yet not once was the client offered a simple retirement plan, some projections, a roadmap to tell him if he is on track or not. Without a plan there is no rhyme or reason behind the allocation of various investments inside a portfolio. It is certainly true that if you don’t know where you are going then the road you take doesn’t matter. If you are currently retired, or within 10 years of retirement, have a plan completed.
Step #2- Analyze Your Investments (Or Have Them Analyzed)
A thorough and sober analysis of the holdings in your portfolio can yield huge surprises. Most of the time, when helping investors with this analysis, it becomes readily apparent that the investor is taking on too much risk without even realizing it. Most investors quite simply own too many stocks as a percentage of overall holdings. What they don’t realize is, when a true risk/ reward analysis is performed, their portfolio contains an incredibly high level of volatility and risk as compared to expected return. Sometimes making a few simple changes can enhance returns and reduce risk significantly.
An extremely valuable tool is called Monte Carlo simulation. This software runs your portfolio through 1000 separate lifetimes, based on real historical stock market results and volatility, so you can see the range of possible outcomes. Many investors are quite shocked to realize that their bread and butter 60% stocks 40% bonds portfolio can yield a huge range of results. Just this week I performed a Monte Carlo analysis on an investor portfolio. The 90th percentile of returns was approximately $3 Million. The 10th percentile of returns was that the family runs out of money before age 80. Why would anyone want to leave their retirement investment plan to such a wide range of possibilities? The answer is that most investors never have this analysis performed. Once you are armed with the proper information and perspective you can now make wiser investment decisions.
Step #3- Look Beyond the Traditional
There is an extremely valid and logical reason that Yale Endowment Fund has been gradually reducing it’s exposure to public stocks and bonds since the 1980’s. The addition of alternative assets such as farmland, private real estate holdings, private equity, gold, absolute return strategies, and certain hedge funds can reduce overall portfolio risk, when used properly, and enhance returns. These asset classes have been found to complement publicly traded stocks and bonds to obtain the best of all worlds. Of course, thorough analysis and research must be conducted, and individual security risks and liquidity considered.
Stock market corrections can be quite painful and stressful but they don’t have to be. The first step to become a very good investor is to understand why you make decisions. This requires self-examination which is the most difficult but also the most rewarding. Determining if emotions or logic truly drive your investment decisions can be life-changing and open an entirely new world of possibilities. I would also strongly suggest that, if you do not have a basic retirement plan in place, to have this performed. Then a proper analysis of your investment portfolio and you are well on your way to success and “peace of money mind”!
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