Sunday, October 30, 2016

A Popular System for Guaranteed Investment Losses

“This market sucks; I just sold all my stock.”
– A friend, first quarter of 2016.

My friend panicked because the stock market dug a hole in his net worth. In his frantic state, he sold all his stock thus purchasing the hole and moving in. 

He wasn't alone feeling dread. Analysts discussed what the drop meant for the economy and our portfolios. Maybe this was “the bubble” popping! Maybe this is a recession. Maybe none of us will ever be able to retire. Or maybe the market was “taking a break” for a while. In any case, I heard no positive interpretations.

Fear of loss damages our capacity for rational thought. My friend didn’t predict the market’s loss — he sold in the dip, not before it. His predictive powers missed the dip. Why did he try to predict again? Selling stock prophesies loss. You wouldn’t sell an asset if you thought the value would increase. He bet a second time on a skill that failed him once.

My friend was so worried about losing money that he didn’t honor the premise of long-term investing. Instead he looked at the trend of the last few days and extrapolated the future. He engaged in market timing – acting on a prediction of the future. My friend was scared of the market’s future.

I felt excited about the dip. Instead of catastrophe, I saw discounts. Now I could buy my favorite investments even cheaper. People like my friend were selling me their stock cheaper because they were nervous about the future.

I went on an index fund shopping spree. I had some extra cash that I didn’t need to spend or keep in my emergency fund. Instead of my scheduled, once a month investment, I accelerated my purchases to several times a week. I didn't use money I would need in the short term. I still invested for the long term. I just did it faster.

Was I timing the market? Yes, I was. I feel a little guilty about that. I invested more frequently because I predicted the market would eventually recover from the dip. I didn’t anticipate a date for a recovery, but a purist would still call it timing. Perhaps I am too emotional in the opposite direction of my friend. Better that than defeating my entire investment plan!

To mitigate my investment risks, I always spread my long-term investments over a variety of index funds owning a diverse collection of assets. If I owned mostly individual stocks and bonds, I may have felt differently. Sometimes individual companies continue to suffer even when the larger market recovers. Sometimes businesses or even nations have permanent problems they never recover from. But I had diversity across asset classes, markets, and sectors.

I also didn’t expect to need the money from my investments any time soon. If I did, I wouldn’t call it long-term investing. I don’t plan to retire in the next ten or twenty years. Barring a cataclysm, the market should be out of the dip before I'd want to retire. Even the Great Depression was over after a dozen years.

My net worth dropped by thousands of dollars. Perhaps that should worry me. Obviously I want the market to shoot up and make me rich, but fluctuation is a natural part of the stock market. Life means fluctuation and change. Seasons come and go. Unexpected events happen. Even the best cities can experience natural disaster. Hurricanes hit New York. San Francisco has earthquakes. Floods fill the basements of the Louvre.

But when the Seine jumps its banks, Parisians didn't sell their homes hoping to buy them back after the flood recedes. We instinctively understand the impracticalities of selling property during a disaster. Stock? Not so much. Investing in the stock market without a tolerance for a drop in value is a guaranteed recipe for losing money. Drops happen. To make money you need to sell with gains, not losses.

Even though we might not have an immediate need for the money, we hate watching our net worth falter. We feel a loss in our net worth much more painfully — and for longer — than an equivalent gain in our net worth. Investment success requires the right mentality.

Instead of thinking “losses”, think discount. Don’t worry about what investments you already have. Pretend you have no investments. Worry instead about whether at this new price you’d like to buy these investments. Or, if you’re capable of more rationality than I am, ignore it all and continue your investment plan unchanged.

Gains in the stock market come from steady growth, dividend re-investment, and occasional periods of rapid growth. Other than scheduled dividends, I know I can’t predict when gains would happen. I’ve lost money trying silly technical analysis ideas. I’ve also lost money reading quarterly reports and looking at fundamentals. I’ve lost money following expensive financial advice. None of that saved the the pain and embarrassment of bleeding money through short-term trading. Predictions have terrible track records.

Since I now admit I can’t predict the future, I no longer sell when things look bad. If I abandoned the market, I would transform my current losses into cash and risk missing out on market gains gains. Was I really prepared to skip dividends and a potential leap in the market? Not a chance. Instead of fleeing, I continue to add money when the markets are down.

My friend? His fear cost him dividends, gains during a fast climb out of the dip, and steady growth of the market to levels above the beginning of 2016. He probably locked in a 8% loss from the start of the year. Meanwhile the market has experienced about a 10% gain from January 1st 2016.

If he continued investing instead of selling when he felt the pain, he could have experienced an 18% gain on his new investments, along with the 10% gain on his previous investments. That’s a missed opportunity turned into a painful loss.

Do you intend your investments for the long term? Do you use a balanced, diverse index fund strategy? Do the research. Does it make sense to stay invested even when the markets are down and CNN is predicting the end of the world? Does it make sense to invest more money in that situation? I think so.

If you agree with me, be strategic. Arrange your investments so that fear won’t motivate the wrong decisions. Automate your investments. Ignore the financial news. Don’t invest money that you will need in the next ten years.*

* This isn’t personalized financial advice. Agree with me at your own risk. Do your own research, run some simulations in a spreadsheet, and consult with professionals who understand your financial situation. Beware brokers and “free” financial advisors. Use professionals who you directly compensate and who don’t have a conflict of interest!

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