Investing in Times of TurmoilSubmitted by U.S. Wealth Farmington Valley on April 23rd, 2020
The Psychology of Investing: Why It Matters to You
One of the questions that many ponder these days is how we should be investing in tumultuous times. Is there a proper/better way for the average investor to structure his/her portfolio? Pretend you are doing your own version of online “Zooming” right now, and let’s review together.
To better understand that question and how to appropriately answer it, I find it helpful to review the psychological principles at work in investment and investment decision making. BlackRock has some helpful steps to understanding these psychological principles:
- Proper investor behavior is critical to investment success
- Common investor biases are a challenge (for everyone)
- Envy: Regret, S&P Envy, Lottery Ticket Effect
- Loss: Compounding, Time vs Timing, Following the Herd
- Work with your financial advisor to build in discipline and ensure you are reacting to the market rationally.
- Be critical, even when times are good
- Be opportunistic, even when times seem bad
Become a disciplined investor, the sooner the better.
Let me repeat the main point:
Investor behavior can be the most impactful factor to your bottom line.
All investors have to get over the envy of the “other,” who brags about how successful they are at investing (probably hot air), and the fear of being left behind in their investments. Research has shown that a properly diversified portfolio will generally out-perform a more narrowly focused investment philosophy over the long term. Thus, your financial goals are supported by your plan and risk personality.
A diversified portfolio, however, can be difficult to own – it never feels like you are winning, which often leads to a feeling of regret. We start to wonder to ourselves, “Why am I losing money? I thought my portfolio was diversified?” or “Why does my portfolio always under-perform? I am leaving too much money on the table.” This kind of regret and not understanding why we build portfolios the way we do can lead to bad investment decisions.
But the reality is, if you add up all these periods, the diversified portfolio generally produces the results we need with the amount of volatility we can tolerate. It wins even though it never feels like you are winning. The chart above from BlackRock illustrates that effect.
The job of a good financial advisor is to build and manage a plan and portfolio that keeps you properly invested to pursue your short-term and long-term life goals. The investment process of Dimensional Fund Advisors (DFA) provides the academic and results-based research to support this philosophy. We partner extensively with them and BlackRock to build our clients’ portfolios.
The difference with DFA funds is that they employ decades of academic research to demonstrate that investors who take the risks associated with diversified portfolios are rewarded mostly with premiums resulting from four areas, which they refer to as “Dimensions of Return.”
- Stocks have higher returns than bonds over the long term.
- Smaller companies have higher returns than larger companies.
- Value companies have higher returns than growth companies.
- Companies with higher profitability have higher returns than those with lower profitability.
If you have questions about how this might apply to your financial goals, please contact us. We can show you our planning process and discuss how it can work for you.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Investing involves risk including loss of principal.