Get Off the Emotional Whipsaw

Get Off the Emotional Whipsaw

We had two fabulous phone calls from brand-new clients a few weeks ago. Both had concerns that are shared by many, and both, despite emanating from completely different perspectives, speak to the very same issue.

So their concerns might be applicable to you.

If you're a client of our firm, you know we take a long-term view. We are not terribly interested in what the stock market does today, tomorrow, this week, this month, this quarter or this year. Instead, we’re concerned about your ability to pay for college for your kids, amass enough for your own retirement, support your aging parents and meet all other financial goals. With a focus like ours, the latest what's-hot and what's-not lists are irrelevant.

We’re able to focus on each client’s long-term goals thanks to our diversification and rebalancing strategies. Before I get to the two calls I mentioned above, let me offer this brief description of diversification and rebalancing in case you need them. If you don’t, you can skip down.

Diversification

Diversification acknowledges that nobody can predict future investment returns, but we can seek to manage how much risk we take. We know different kinds of investments behave differently when different events occur. Changes in interest rates, inflation and the value of the dollar – even the weather! – cause investment values to change. But some investments rise during a given change, while others fall. And still others are unaffected. That’s why we diversify: to reduce the chance that all our money might fall in value at the same time.

So instead of owning just stocks, we add bonds. A portfolio of both is lower in risk than a portfolio that owns just one or the other. To further reduce our risk, we add real estate, foreign stocks, commodities, government securities and more. The more we diversify, the more we can reduce our risk. And when we do it correctly, we don’t necessarily reduce our potential for earning the returns we expect.

Rebalancing

By owning a diversified portfolio, we know that one asset class will rise while another is falling (we just can’t predict which will do which at any given time). That generates a divergence in returns. So if we start with a portfolio of two assets, holding half our money in each, that 50/50 allocation will drift over time. At some point, one of the assets will rise (or fall) more than the other, turning our portfolio into a 60/40 allocation. To get it back to 50/50, we need to rebalance it. That means selling some of the asset that’s risen in value and using the proceeds to buy the asset that’s fallen in price. In other words, rebalancing gives us the opportunity to sell high and buy low – a wonderful way to grow wealth!

Back to Those Client Calls

I don't think the first client who called understood diversification and rebalancing.

He opened his account on Monday.

The Dow fell that day, by 106 points.

Tuesday, it fell 51 more points.

Wednesday it fell 268.

Thursday it went up 63.

Friday it fell again 315.

For the week, the Dow went down 678 points.

That's when he called. "I lost $7,000 in just one week," he said.

"It could have been a lot worse," I replied. "Fortunately your account is diversified. Your loss was only $7,000 – it might have been $17,000."

That didn't mollify him much.

He was focusing only on the short term – five days! – and not on his long-term goals. He was also focusing only on the stock portion of his portfolio and not the rest of his account. He hadn't even given us the opportunity to rebalance.

And so he was asking, "What if this keeps happening?"

Well, the next week the Dow started by dropping another 100 points on Monday, and 112 on Tuesday.

But then investor sentiment changed, and the Dow skyrocketed 288 points on Wednesday and other 421 points on Thursday, gaining another 26 points on Friday.

A gain for the week of 524 points!

For the entire two-weeks, the Dow was down only 154 points. No big deal. Proving to this first caller that we mustn’t focus too much on daily activity in the stock market.

But the Dow’s increase led to the second phone call from another brand-new client.

With the Dow up 524 points that week, the second caller complained that he had only just sent in his paperwork to us, and we didn't get it invested in time to capture the market's jump in value. He was upset that he missed the opportunity.

Again, he was focusing on the short term.

He was ignoring the fact that we weren't going to put all his money into the stock market anyway. He was also ignoring the rebalancing we do over time.

Both of these new clients had totally opposite perspectives. One, fearful of losses, worrying that there would be more. The other, annoyed he missed a short-term increase, worrying he might miss more.

Both were suffering from short-termism.

I want to make sure you learn the lesson (as these gentlemen did, by the way; it was our bad that we didn’t sufficiently explain to them what they should expect from their accounts, or our long-term approach. They get it now).

If you've felt whipsawed about your investment performance, a talk with your advisor might help. If you don’t have someone to talk to, or if you’re not satisfied with the answers you get, give us a call. We’re happy to chat!