We all know that investments go up and they go down. The problem is how we handle the emotional roller coaster of watching our investments decline in value. As I am nowhere near qualified to act as a psychologist, my thoughts and ideas are my own as to why this happens. I base this on having watched hundreds of clients experience this dilemma and have even experienced it myself multiple times.
Everyone’s heard of the fight or flight response. It’s that fear response that picks up any time we feel threatened. This can be a physical threat, emotional threat, or in this case a financial threat.
When you see your investments going down in value, this fight or flight response kicks in. We have this instinctive reflex to try to avoid as much pain as possible. Our emotional response is to try to do something, sometimes anything, when the rational and logical strategy would be to simply stay put.
It’s why we move on from underperforming investments at the worst times and chase the high flyers even though we know we should never sell low and buy high. It’s why when the market is plunging we desperately attempt to time the market and sell out as it’s falling, with an illogical hope of timing the bottom and buying back in.
Then what can we do about it, and how do we avoid it?
Well, whether we are discussing how to handle an underperforming investment or riding through a capitulation point in a market crash, my advice is the same.
The first and most important piece of advice is to understand the point that you would succumb to panic. If you knew seeing your portfolio drop 40% during a major economic event would cause undue stress and panic, then you need to build a portfolio that will never reach this point. The thought that we can avoid downturns is a fool’s game, but building a portfolio with a targeted maximum loss is something that can be statistically created with a relatively high degree of probability.
Once you’ve determined this point, and come up with a portfolio targeted to never go down more than that, it’s time to accept that eventually, it will happen. From here you need to come up with a strategy of what you will do when it does happen. Having a predetermined strategy will allow you to fall back on your prior logic and decisions rather than succumbing to your emotional panic during the crisis.
The strategy we typically employ is to simply rebalance your portfolio. #1 Assume it was 50% stocks and 50% bonds, with a $100,000 account. #2 The stock market drops 50% and you’re panicking. You now have $25,000 in stocks and $50,000 in bonds. #3 To bring your portfolio back to 50/50, sell off $12,500 in bonds and buy $12,500 stocks, bringing your portfolio to $37,500 stocks and $37,500 bonds. #4 Then you wait until the stock market fully recovers, bringing you to $75,000 in stocks and $37,500 in bonds. #5. Once the market has fully recovered, simply rebalance back to 50/50 leaving you with $56,250 in bonds and $56,250 in stocks. Even though the market never made any money in this period, your willingness to rebalance during times of stress allows you to actually make money. While it may seem counterintuitive, in my experience simply having a strategy as a way to profit from this decline, can oftentimes be enough to satisfy a client’s urges to just do something.
The key to this, however, is to have already agreed to do it before the crash happens. Then, have a history of irrefutable data about how great this strategy has performed historically (hint: it has worked 100% of the time in history).
Instead of your emotional capitulation being a way of losing, we can turn it into a method of profiting. But only if you build a portfolio with a downside risk you can withstand, and by having a predetermined plan of attack for when it happens. Otherwise, you will end up like the millions of others who sell out during a major crash and suffer the consequences.