So the last 12 months in the equity market have been interesting. Last fall, the markets were in turmoil declining over 14% for 4th quarter. The S&P 500 was down as much as 9% in December alone. Certainly, unnerving performance for most investors. Conversations with our clients involved answering questions about how low the markets could go and what steps they should be taking to limit their losses. Clients’ appetite for risk was very low and fear, was by far, the overriding emotion being demonstrated in most of our client interactions.
Moving into 2019, most expected the US equity markets to continue their volatility given their performance in the fall. Yet, halfway through July 2019, the S&P 500 is up 19.74%. Now, 7 months later, clients are demonstrating ‘S&P Envy’, curious why their portfolio is not up as much as S&P Index. The fearful conversations from just a few months ago have disappeared. Clients’ appetite for risk has increased substantially and greed is now the common emotion.
Understanding this whipsaw experience is important for investors. One’s tolerance for risk is clearly a function of the markets and how an individual feels about them. It’s contextual and this concept was proven in a recent research study where participants were presented with a full glass of water. The researcher poured half of the water out of the glass and asked the participants how they viewed the glass. 69% described the glass as “half empty”. When the same glass started out empty, and the researcher filled the glass halfway, 88% of the participants answered the glass was “half full”. There was no difference in the amount of water in the glass, yet the responses were significantly different. How the participants felt about the glass changed their perspective from negative to positive.
I had a similar experience recently with a client regarding advice we provided with their son’s 529 plan. As children get closer to using the funds in their education account, our advice is to generally “de-risk” the portfolio by removing each year’s tuition out of the equity markets. Our advice is to place the funds into cash to avoid a possible market decline right at the point when the funds are needed. Last summer we advised a client to do so in anticipation of their son’s first tuition payment due this August. As the equity markets tumbled in the fall, the client reached out to say how pleased he was that he took our advice. His fear had subsided, and he clearly felt good about the advice. The conversation with the client, however, was much different just a few weeks ago. “I guess you were wrong about moving the money out of the market” he said during our recent visit. “I missed out on all the growth in the markets this year. I would have been better off leaving the funds as they were, I would now have more in his account.” Clearly, his appetite for risk had changed tremendously given how he now felt about the markets. The fear and concern he demonstrated last fall had given way to his desire to simply grow the account, despite the risk. Greed had taken over. The fact is, however, the risk of a market decline is no different now than it was then. He simply felt different about it. And by the way, the fact that the risk didn’t play out, does not mean it was not present to begin with. If you go an entire year without a claim on your homeowners’ insurance, was it a bad decision to insure your home for the year? Of course, not. The fact that the risk never materialized, does not make your decision to insure your home a bad one.
Being a successful investor involves understanding these investment biases and how they can affect the risk you are taking within your portfolio. When making changes to your allocation and thus the risk within your portfolio, its important to ask yourself the reason for the change. Is it due to a change in my goals, my time frame, or the addition of other resources? Or is simply an emotional reaction to how I am feeling about the present-day markets. Avoiding the emotional reactions and remaining focused on your financial plan may not always feel good, but it is almost always a better approach for better outcomes.