In difficult markets like the one we’re going through now, the number one question I get from prospective clients is ‘what should I do now?’ It’s a question that can’t be answered without taking several things into account that will provide context. These things include how the client is invested today, how long until the client will start making withdrawals, and how much downside risk the client can tolerate. There is no standard answer that fits all situations.
The way most investors get into trouble with their portfolios is by making decisions that are based on emotions like fear – specifically fear that the market will continue to decline and never recover. Fear of losing so much money in the market that they will never be able to make it back. If the investor has a limited time frame, like 5 years or so, then this fear is appropriate. But for longer time frames, it’s irrational and can lead to serious mistakes.
This is why we teach our clients how to set up a clearly defined strategy that includes contingency planning for markets like this one. A well-coached investor doesn’t have to ask ‘what should I do now’ because he already has the answer. It’s written in his plan, and therefore the emotion is removed from the process. Having a contingency plan puts the investor in a position of strength and confidence. Without a plan, emotions rule the day.
Studies of investor behavior during times of market stress have shown that investors tend to sell their holdings too late in the market cycle. This is what we would expect when decisions are driven by emotion. The studies further indicate that these investors who sold too late also stay out of the market too long, fearing that they might get burned again. By the time the market recovers and moves to new highs, these sold-out investors have missed out on the most profitable part of the investing curve. They will eventually throw in the towel, and pay a high price to get back into the market. This ‘sell low and buy high’ tendency guarantees that the average investor will greatly under-perform the market averages over time. But it doesn’t have to be this way.
During the coaching process, we help our clients set up parameters in the form of trigger points for making portfolio decisions. As an example, an investor who has a very low tolerance for losses might set up a trigger at the -10% level. When the value of their portfolio declines by this amount, the client will get an automatic notification via email or text message. This pre-determined loss limit allows the investor to take the action that’s appropriate for his circumstances, and emotions are reduced to a minimum.
There are many other advantages to having a structured framework in place for decision-making. We’ll discuss them in future articles. If you would like to read all about how we help clients to set up their parameters, drop us a line at info@zeninvestor.