If I told you today that the Dow Jones went down 500 points, we’d all say, “Wow, what the heck happened?” And for some of us, market volatility might cause more trepidation than optimism. Well what if I told you instead the S&P dropped 59 points in one day. How would you respond? Maybe, “Who gives a rip? It’s 59 points!” Does the market sound volatile in that scenario? Let’s talk a little on this phenomenon called behavioral finance (see video).
If you do the math, both of those numbers equals 3% of their respective indexes below…
500 points/16500 points in Dow Jones Index (DJIA)= 0.03 x 100% = 3% drop
and… 59 points/ 1950 points in the Standard & Poor’s Index (S&P) = 0.03 x 100% = 3% drop
1st- Understand the implication of the numbers. What’s the number behind the number really mean? The numbers look bigger in one index, but the percentages are the same in both indexes when it comes to measuring market volatility.
Figure 1. – Market volatility and correlation of stocks to historical events. (Source: Business Insider)
Above (fig. 1) is a good example of late 2012 with a backward looking view of the daily market volatility. It shows a 3-month moving average in the Dow over 90 years with every major event you can imagine. To be honest, a 3% swing in one day is somewhat significant whether it’s negative or positive. There have been times historically where the indexes have fallen in a matter of days and sometimes weeks of anywhere from -10% or -20%. When we see on the news bold headlines- DOW FREEFALLS 500 POINTS we can panic out of fear. We’ve been trained as Pavlovian dogs the past few decades to cower in fear more than to invest with optimism. This is where we can sometimes show our true colors and understanding of the stock market and investing- in effect, this causes more market volatility. We forget about the long-term because we’re suffocated in the short-term with no deeper understanding of how to interpret the numbers, so study what the numbers really mean.
Figure 2- Media headlines and the relation to market volatility (Source: Federal Reserve)
2nd- Understand the news media’s motives. I’ll try to be short with this thought. Be sure to apply the statement of ‘don’t believe the hype’ with your financial lens. Whether it’s FOX, CNN, CNBC, MTV, or HGTV – whoever- they all have their motives to get as many eyes and ears to get revenues by selling Today (fig. 2). I believe it’s harder today to aim at avoiding bias and look at the facts objectively. The media inundates us 24/7, and mirroring the negative news becomes a self-fulfilling prophecy and amplifies market volatility. The Nazi Propaganda Minister Joseph Goebbels once said, “If you tell a lie big enough and keep repeating it, people will eventually come to believe it.” We’re no longer concerned much about yesterday or five or ten years ago because we’ve forgotten History (past lessons in our country we now consider boring). Instead of watching a T.V. show that doesn’t have any understanding of Economics, Finance- again throw History in there too- listen to subject matter experts, and how that relates to your day to day financial life and decision making. Read more books with subjects on investing and dialogue with trustworthy experts. None of this sounds sexy. It’s boring at best, but vital for investing.
Figure 3- Short term market volatility should dictate longer term financial goals. (Source: Slideplayer)
3rd- Understand your goals both short, mid, and long-term. It’s about you and your financial goals! Some of us wish we had long term goals. Some of us don’t know how to plan for the next month. It can be intimidating and discouraging. Start thinking today and take baby steps. What about that $10-15k that you have sitting in that brokerage or bank account? Ask yourself, how soon will I need that money? Is it an emergency fund for the next 2-3 months (fig. 3) to protect from a possible shortage in pay or job loss? What about that tax deferred 401k retirement plan that has $20k sitting in cash the past 10 years? Do you have a realistic plan? Do you understand the power of tax-deferred compounding growth of 4-7% for the next 20, 30, 40 years of your life?
If you are starting at ground zero, a good start may be a monthly investing goal of $200 in an investment account with low expense ETFs or no-load mutual funds. This costs very little, and is a simple way of priming the pump. For those more risk averse, this also reduces risk when you spread investments out over a time period of months or years versus a lump sum of money at one point in time. Or combine both of these strategies. I have no regrets when I started investing at age 18, and it’s taught me huge lessons. This also makes a huge difference if you discipline yourself and commit contributing to a tax-deductible, tax-deferred retirement bucket (aka IRA or 401k). Retirement accounts are designed for your long-term strategy. So, if you plan on using the money in the next 6-12 months then a non-retirement account is better (i.e. bank or brokerage account) because it will likely be harder to get a return you’re looking to make. Taking risks with short-term money in stocks is especially harder in the volatile and somewhat unpredictable markets currently and over the past year. On a different note, in the intermediate term, your strategy may make more sense in a brokerage account if you know this investment will be needed in the next 2-5 years. Tax implications will need to be considered and you may need a tax professional to thoughtfully guide you along the way.
Last, and maybe the most important- understand the risk YOU are taking. Know yourself by going over a risk tolerance review as one example. Many young investors in their 20’s and 30’s, may be a little more hesitant to just throw their hard earned money 100% into the stock market after seeing and maybe experiencing the 2008 crash. If your psyche didn’t get to you and had a more disciplined approach you would have been better off. Your investment in an S&P index fund would have paid off and accumulated over 153%% in a matter of 7 years from March 2009 to March 2016 if you held on- this is an aggressive tolerance and more long-term strategy. Further, if you reinvested dividends on that S&P index, the returns would have made 191%. So, if you’re looking to be in investments for 5-10+ years, create a longer term plan and not the media hype plan. If we’d look at the images of history (fig. 4), it would teach us about investing when you look at events which riveted stock markets like the crash of 1987 or 2008, the Vietnam or Gulf Wars, the tech bust in the early 2000’s along with the event of 9/11.
When it comes to risk, you want to ask yourself if you’re comfortable with the chance of loss or growth of principle of 5, 10, 20 or 30% in any given year? How did you respond and how was your attitude during that low? Your overall rate of return expectation is heavily tied to whether you are conservative with risk (Tortoise), moderate risk (what I call Tare or Hortoise), or aggressive risk (Hare). Historically, being in a stock heavy or bond heavy portfolio over the past 5, 10, 15, or 20 years for that matter using proper asset allocation would have paid off. It’s the proverbial “not all eggs in one basket”. The strategy of sitting in cash or getting in all gold, or bitcoins or any one asset class for that matter increases significant investment risk. Consider a diversified asset allocation thru your retirement plan no matter how conservative or aggressive you may be. Have an actual relationship with an investment professional to meet, and re-balance your portfolio based on your evolving personal financial goals, risk temperament, and forward looking market expectations. So remember, you only get in returns what you personally are willing to risk, and most of that is in the long, not short-term lens of investing. Welcome to what we define in the financial services industry as Behavioral Finance.
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