(Un) Emotional Investing

One of the most basic tenets of investing is that the higher the potential returns, the higher the associated risks. Pretty basic stuff - unfortunately some people tend to forget that when times are good. They promise not to panic when markets fluctuate, (and they will do so again at some point in the future) and they lose money. However after a sudden slump, your investments drop and fall below what you paid for them. The risk is now terribly real. You find yourself watching the business news, trying to understand what is happening and imagining the worst. It is now that you really understand what risk is really about. When markets are headed on a straight line up, the only questions advisors hear is "why did my fund only make 10% last year"? When they drop sharply like they did in 2008, people begin to question "why they invested in the markets". The graph below shows the typical market cycle and the "emotions" attached to that cycle.

It looks like a pretty simple thing to follow - red is a bad time to buy, and green is a good time to buy. Unfortunately, most people (experts included) don't know exactly when we are in a "green or red" time frame. When markets drop in value, people have a tendency to forget their long-term investment strategy. Risk tolerance questions and Know Your Client forms help advisors to understand your "investment psyche". Once you establish your comfort zone, stick with it regardless of the market (changes in your personal situation are different).

Founder and President of Strategic Imperatives, Dan Richards ranks among today’s leading authorities on strategies for financial institutions and financial advisors. In a recent video interview, he discusses the impact of the recent market meltdown on both investors and advisors and the results will surprise you.

The pyramid on the left shows something that I have often related to people. 92% of the returns of an investment portfolio, be it stocks, bonds or mutual funds are dependent upon the mixture of assets you hold. 6% of your returns are dependent upon which investment company's plan you bought, and the remaining 2% on when you bought or sold. This assumes you bought investments on a regular basis (monthly or less), and didn't bail at the first hint of a market decline. In other words, if you are aggressive and hold all of your money in the stock market, 92% of returns are based upon the Canadian stock market. The other 8% are affected by which Canadian equity fund you bought and when.

How do we remain "unemotional" about our investments. Here are a couple ways to approach it.

• By agreeing and arranging to dollar cost average (DCA) by making preauthorized purchases of the same amount of money each month into the same investments. Each year you can review the amount you deposit and see if you can afford to do more. Look at the chart below - see if you can guess the returns for a lump sum on January 1st or monthly purchases for the full year. (Answer below in big bold red).
• By realizing that a long term goal is just that - long term. If your need is short term, then invest that way. If you're 38 and plan to retire "around 60", then realize that markets will have sharp drops at least 3-4 times before you retire.
• Picking a future date (say 5-10 years from your estimated retirement date) and then and only then making any dramatic changes to your plans

All that being said, you still need to be mindful of serious problems. The stock going through a major correction is not something you or your advisor can control. Losing your job, divorce or the loss of a spouse, or a major health problem are factors that require you to reexamine your plans. Other than that, it makes little sense to change your plans every time the markets go up or down.

The chart above shows the actual monthly purchase prices if you DCA'd for the year 2001 (our last recession). A lump sum on January 1st meant a loss of 13.9%. DCA still produced a loss but it was only 1.1%

Perhaps the best advice of all comes from Warren Buffett. In his annual "Chairmans Letter" to shareholders in the Berkshire Hathaway group he stated. The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.