Of the world’s many mysteries, Wall Street’s success at convincing Main Street to believe in the existence of long-term investors ranks high. Through incredible marketing campaigns and repetitive messaging, Wall Street has persuaded people who dispute the existence of Leprechauns and Unicorns to see themselves in some idealized version where they are calm, cool-minded observers and actors in one of the most erratic, chaotic environments. When the market convulses and devours large sums of their money, these long-term investors simply smile, remain calm, and call their advisors to thank them and make sure they are remaining cool, calm, and collected. In reality, that rarely happens, and that is because barely anyone qualifies as a long-term investor.
Most investors never own a portfolio of stocks that they carefully curate for decades. The only thing that is truly long-term about most investors is the amount of time that they spend in the market. Most investors never own anything long enough to benefit from the market’s cycles. They instead spend an extraordinary amount of their time in the market acting like salmon swimming upstream against the current, perhaps getting devoured by larger predators. This may seem a harsh conclusion that will upset some people, but it captures the experience that most of Main Street typically has on Wall Street. As a result, many individual investors are psychologically off-balance.
They greed in and panic out of the market at precisely the wrong times. This is why so many have lousy returns, and poor opinions of the financial markets, advisors, and banks. And yet there are some hopeful signs that people are finally starting to wise up.
In 2017, the Nobel Prize for Economics was awarded to Richard Thaler, who integrated economics and psychology. He developed the theory that investors simplify their financial decisions, narrowing the impact of individual decisions rather than considering the overall effect.
As the Royal Academy of Sciences noted in announcing the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017, Thaler’s work details how “succumbing to short-term temptation is an important reason why our plans to save for old age or make healthier lifestyle choices, often fail. In his applied work, Thaler demonstrated how nudging – a term he coined – may help people exercise better self-control when saving for a pension, as well in other contexts.”
Thaler’s research suggests that short-term losses have a more lasting impact on investors by encouraging risk-taking, and more aggressive behaviors, to recoup losses.
Few clients fully appreciate that they can only take out 4% of their money before they trigger depletion schedules. They like to think that the market heals all wounds. But everyone has psychological triggers. A sharp dip, even short-term, can cause investors to panic and worry about the future. Some will rotate into cash, or other dead money asset classes, and others will take on more risk to try to recoup what they lost. It is a vicious cycle. Even in 2018, as the U.S. stock market was trading around historical highs, many advisors confessed that many clients had missed the rally, and they were finally ready to use their cash stockpiles to buy stocks. Only time will tell if those approaches are prudent, but this is a fact: the higher the loss, the greater the required subsequent gain, a phenomenon known as the asymmetry of losses. For example, if an investor loses 20% in a year, dropping from $100 to $80, the portfolio must gain 25% the next year just to recover the original value. ($80 x 125% = $100).
Harry Markowitz, whose ideas animate the concept of diversified investment portfolios, coined his ideas in 1952. The world has dramatically changed since President Harry Truman was in office. In recent years, many seasoned investors have come to believe that Markowitz’s MPT or Modern Portfolio Theory is an elegant mathematical model and not much more. These debates are far from academic for anyone who must rely on the financial markets for their retirement.
StratiFi’s PRISM Ratings™ risk scoring technology provides RIAs, asset managers, and broker-dealers more insight into the risks in their clients’portfolios and their own business, so they can pick the risks they want to take. Contact the StratiFi team to find out more and get started today!