This year marks my 36th as an investment advisor. While I have memorized in great detail many of the curveballs the market has thrown my way in the last four decades, I’m still more a student of people than markets. Investing is an emotional art form with very little science, although Wall Street does a great job of creating the illusion of scientific certainty with their expensive strategies. Even if they were scientifically advantageous, it’s all moot if clients make emotional mistakes. For these reasons, markets tend to do well, but people generally do not. I have several explanations for that, by way of a professional lifetime spent listening to clients tame or get consumed by their demons.
Investors tend to live in a mental state that understands life’s normal boundaries. I envision it as a series of concentric rings, much like a Target store logo. We live in the center dot if you will. All of what we expect to occur resides within the bounds of that dot or ring. When those red and white boundaries get breached with surprises like COVID-19 or a 2008 crisis, we begin to calculate our risks and the possibilities of “new normals” in those other rings. When our second ring of possibilities gets breached by violating our expectations further, we often go to heightened alert or even battle stations. Depending on our amount of alarm, this is often where we begin to envision “worst-case scenarios,” which I term as “panic-induced-over-estimation.” This is where we tend to make our largest mistakes by preparing for 6th and 7th ring events that are highly unlikely to occur. As a matter of fact, this is most likely to occur on the cusp of everything retreating to the center ring and normal life resuming. You can see the treachery in that.
I think we make our worst mistakes due to emotional fatigue. We simply want the bad news to stop, so we rearrange our risks in order to reduce its significance in our lives. These moves can have everything to do with how we internalize stress or how little margin for error we have, perceived or imagined. It’s also important how true and accurate our self-assessment was when we constructed our portfolio. If we over-estimate what we can endure, we’re sanguine as long as it all goes our way, but moods change when the tide goes out. Adjusting late, rather than at inception, is the fly in this ointment. Long term financial repercussions are not caused by market swoons. Markets will always go higher. Not being in it to win it is clearly the nemesis. A reduced risk profile at the onset might have allowed us to stay put longer and avoid messing it all up. The trick here is to avoid the siren song of how much better it would be if we stayed full throttle 100% of the time. Clearly, it would be better; but not if we can’t handle the heat in the kitchen.
Since these breaches in our expectation “rings” are almost always a surprise, and only negative breaches count, advance preparation is key. No, you are not smart enough, nor am I, to execute perfect timing of the next move and put the genie back in his bottle. This all starts with a rational talk with ourselves about how we handle stress, and how many digits can truly be on the backside of that -$ sign. But that talk must absolutely occur before the stress starts. This is why foresight action is important, but hindsight reaction must be resisted.
Even if we were to time a market exit perfectly, we grow to love the cash we have instead. That virtually assures a second mistake. Cash is quite emotionally soothing, too, right up the point when we realize the bus has left the station. At first we convince ourselves it will be right back because our smart move to cash cannot be proved wrong so quickly. We convince ourselves we will get another shot at getting reinvested. But in reality, each lower tick in the market will never be low enough because we always think it will go lower still, practically assuring we will miss the low. Then we see the bus crest the horizon in the distance. It’s much better to stay in your seat and not risk getting left behind, at whatever risk profile will allow you to do that.
This explains why my firm rarely makes large tactical moves with client money. We fall prey to the same emotional roller coaster, too, so we have learned to stay put. Portfolios built from the beginning with expectations of rough times, will endure far better than adapting on the fly. Making it up as we go along opens us up to a string of mistakes that often result in participating fully in the downside and then giving away the upside, driven by the emotional reeling of bottom-feeding mistakes. Fidelity recently released a study ranking the performance of their client accounts. The two groups with the best performance were those of deceased clients, and those who had moved and their mail was lost for years. Clearly, the inference is that those who are prevented from intervention will do best, self-imposed and living are preferred.
We see investors put their trucks in the barn at the precise moment everybody else is hauling their filthy lucre to the streets. That’s when we need to be backing up the truck to haul it all off for ourselves.