January 31, 2023

Behavioral finance plays an important role in long-term investment success. We behave as we do in large part because we are affected by our emotions. Fear, greed, envy, and regret are some of the big emotions that often impact our decision-making, and we have all seen their collective influence over the last few years. Indeed, we seem to have had more than our fair share of such “learning experiences” during the past decade or so, from the credit crisis in 2008, to the pandemic, to last year’s various market challenges. Occasionally, these can lead to real crises of confidence, as our combined emotional responses to prevailing conditions get taken to extremes. But it is exactly because of the risks involved—of recessions, bear markets, and sometimes even panics—that it is critical to have plans in the first place, and to have them laid out in advance. Planning requires upfront decision-making, then the discipline and commitment to stick with them to achieve results.

Obviously, if it were not for all the risks involved in investing, everything would be easy! But risks of all kinds do exist, and that is why discipline and commitment take courage. But pure courage is very difficult to muster just when it is needed most . . . such as during market turmoil. It is far better to commit upfront to a plan that will help avoid the need to rely on super-human courage at the most critical moments. Besides, the impact of emotions is not limited to market “bubbles”; emotions continuously affect investors. How else to explain a well-regarded market study that shows from 1992 to 2021 the S&P 500 returned almost 11% annually, but the average equity mutual fund investor received only about 7% annually?* Most investors buy along with the crowd when prices get too high and seem unlikely to ever fall and sell along with the crowd when prices get too low and seem unlikely to ever recover. One can only point to emotions and psychology to reconcile this dramatic performance difference.

But why even bother to take investment risk in the first place? Because there are different kinds of risk that must be constantly evaluated, with trade-offs amongst them. Volatility (or market and price risk) gets most of the media attention and headlines, with stocks being the typical example. But inflation (or purchasing power and longevity risk) also matters, especially affecting interest-generating investments such as bonds. Even “modest” inflation of 3% will cut one’s purchasing power in half in about 25 years. If young enough, one could possibly see an asset base cut by up to 75% or more in their lifetime. This is why inflation is so insidious, and why most investors—of almost all ages—likely need to consider at least some degree of market risk in their asset mix to help maintain “real” wealth over time. This is also why investing should be based on personal plans focused on individual risk assessment and goal setting with a dedicated investment strategy.

Rely on solid fundamentals, sensible asset allocations, and rebalancing. Embrace the capital markets, anticipate various kinds of risk, diversify the asset mix accordingly, maintain sufficient liquidity for any possible short-term needs, and have an overall time horizon long enough so as not to be forced to act at inopportune times. Then deliberately rebalance along the way. Rebalancing is the under-appreciated “secret ingredient” of asset allocation! Rebalancing helps moderate temptations in the extremes, both on the upside—think loading up at just the wrong time in 1999 or early 2007—and on the downside—think dumping everything in late 2008 or early 2020. Rebalancing enables the power of compounding positive real returns to steadily occur over time. Finally, make your Wealth Manager your ally. Frankly, there is no better ally than a fiduciary . . . and that is our job! Our interests are directly aligned with our clients, with no ulterior motive for what we do other than striving to achieve the best possible risk-adjusted investment results over time.

_{*Dalbar, Inc. 30 years from 1992-2021; Quantitative Analysis of Investor Behavior}