Research shows that investors who monitor their portfolios regularly tend to make less money.
Often investors don’t make money even though many funds post strong returns since inception. In other words, why do lazy investors who don’t monitor their investments tend to make more money than investors who are more active? The answer might be the Number One investing tip of all time.
Turns out, it all boils down to two major human emotions – greed and loss-aversion.
How do emotions impact investment returns?
For the last several years, we’ve seen the stock market go up considerably. Most people who invested in it have seen double digit returns.
With Fed rates on the lower end, it seems nothing could stop this bull run. Your money is growing. Your goal of retiring early looks easy to achieve at this rate. Maybe you should retire earlier. Or maybe you can enjoy an even more luxurious retirement lifestyle.
Greed, you see.
Let’s go back to 2007.
Stock markets were doing pretty well. Banks were making a killing. Executives were getting paid an insane amount of money. Everyone was living the dream.
Then 2008 happened. Everything came crashing down. Many of us saw our portfolio values drop close to 50%.
Not a pretty sight.
50% is too much to lose. So you decide to pull out. Better to cut your losses while you still can.
You wait a few years on the sidelines as you see the economy pick up. You have been burned pretty badly so you’re not comfortable entering the market again.
A few more years in, and the markets are soaring. You feel the pain of missing out on that growth. But you resist, because you haven’t been able to come to terms with your losses.
Loss aversion, you see.
Another few years down the line and you see the markets rising again. The markets may be going up for no reason. And you may have to buy high to get back in. But you don’t want to miss out on the upswing.
So you decide to go all in again.
Everything is going great for awhile. Until something like early February of 2018 when markets give you a mild reminder of the 2008 times.
What would you do when the markets crash next?
The question is often not “if” the market will crash, but “when”.
So, do you wait for your portfolio value to go down? Do you wait on the sidelines while the markets recover and buy into the markets again when they are high?
A systematic way to be a better investor
Here’s a fun fact about compounding. You know compounding is good because it helps you grow your money over time. But did you know that the same compounding can drag you down if you don’t act on time during a market crash?
The math: If you lose 50% of your portfolio value, you need to gain 100%, and wait 9 years just so that your portfolio value goes back to the original amount.
Not much fun, is it?
The cornerstone of good investing is proactive risk management.
Risk management does not mean you need the magical ability to time the market. It simply means that you take action by setting aside emotional biases that drag down investment returns.
- Understanding various types of risks and not following the herd blindly.
- Systematically moving your portfolio to cash or less-risky asset classes based on drawdown control.
- Having a plan to re-allocate cash back into the markets.
- Rinse and repeat for the entire lifecycle of your investment.
Portfolio allocation and rebalancing
What happens if you get the secret KFC recipe and don’t add the main ingredient while cooking?
That’s what’s happening with most robo advisors these days. They get one part right – providing easy access to investing and regular rebalancing. However, what many of them get wrong is that they stick to a static allocation. If your portfolio was 80% stocks and 20% bonds when you started, I don’t need to tell you what would happen if 2008 repeated.
Rebalancing is not equal to risk management.
As a smart investor, you need to take action at the right time.
Have a process in place to ensure that when your portfolio value drops and hits a certain threshold, a percentage of your portfolio is moved to cash or a less risky asset class.
The same way you moved from more-risky assets to less-risky assets, you need to have a plan in place when the markets are more favorable to invest. Move from less-risky assets to more-risky assets in a systematic manner.
The difference between market timing and risk management
It’s common for investors to think that you have to time the market as part of risk management. After all, it makes sense to buy low and sell high.
Truth is, risk management and market timing are very different. Risk management is about containing losses while market timing is about maximizing gains. Two very different goals, you see.
Can I just buy-and-hold forever?
Warren Buffet famously said, “Our favorite holding period is forever”. Why would you not want to listen to him? He’s one of the richest people in the entire planet. His fortunes have come from intelligently investing in companies.
Now, read the following excerpt from his shareholder letter.
“In each case, you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.” – Warren Buffett’s 1996 letter to shareholders.
Notice the last part about monitoring? That’s what most people miss. It’s great to invest at the right time. But it’s also important to exit at the right time.
And that’s not all. According to research that analyzed 26 years of trades done by Berkshire Hathaway, Warren Buffett’s investment firm, it was determined that the company holds only about 20% of the stocks for the long-term!
You might do significantly better than the average investor by simply not doing anything. But if you want your hard earned money to work harder for you, you need to monitor your portfolios and take timely action.
“Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.”
Mansi Singhal is the CEO of qplum, an online financial advisory firm. Before starting qplum, she worked on Wall Street for different banks and hedge funds. She received her Master’s in Computer Science from the University of Pennsylvania and holds Series 3 and Series 65 certifications.