The emotional and psychological risks of investing
Reprinted courtesy of MarketWatch.com.
To read the original article click here
If you have money invested anywhere — even if it’s just sitting in a bank — you’re exposing yourself to at least some financial risk. And as an investor, you have no task that’s more important than knowing and managing that risk.
This article, adapted from a chapter in my book Financial Fitness Forever, is the third in a series that addresses the four most important choices every investor faces. The others involve where you put your trust, whether you’re going to try to beat the market, and how you diversify.
Almost all the trouble that investors get into involves risk. Sometimes it’s taking too much. Sometimes it’s taking too little. Often it’s failing to even recognize that a particular risk exists.
Risk comes in various flavors, but they all start with one unavoidable fact: The future is unknown. Some risk is objective, and some is emotional. Objective risks can be measured in money. Emotional risks manifest in forms like stress, worry, and uncertainty.
My definition of risk is unorthodox, but (I believe) quite accurate: A possibility, which you invite into your life, that you could lose something important. That something might be your physical safety, a relationship, or something financial.
This isn’t theoretical. It’s about really losing something. Obviously, nobody invests money in the hope of losing it. But investing is an area in which you get paid for embracing a certain level of uncertainty and discomfort.
The lowest-risk investments such as T-bills, savings bonds and money-market funds offer only modest returns. Most investors take the additional risks of owning stocks and bonds because very modest returns aren’t enough for them.
One basic formula is inescapable: Higher risk goes hand in hand with higher expected returns.
I’ve covered financial risks elsewhere. In the rest of this article I want to focus on emotional and psychological risks. Even though they can’t be objectively measured, they are very real.
Let’s start with a guarantee I have made to many people: If you invest at all in the stock market, you will lose money. Some level of temporary loss is simply inevitable. When the market heads down, real people lose real money in real time. There is no way to avoid it.
Successful investors learn how to react properly. But lots of people get this wrong.
When things are going well and everybody seems to be making money, it’s easy to invest. Emotional risk is low. As prices keep going higher, financial risk does the same. The higher you get on the upward curve, the closer you are to the point when the curve starts downward.
Conversely, when the market has been doing poorly, fear is much stronger than greed. Yet this is the very time in the market cycle when financial risk is relatively low.
In practical terms, this means that if you follow your emotions to get in and out of the market, you will do the wrong things. Fear and greed will lead you astray. The best investors are those with the patience and the perspective to do the opposite of what the masses are doing.
So what’s the answer? I think the answer is moderation. Trying to get rich quick can be very dangerous. Giving up too easily is also dangerous.
I believe the best defense may be to have somebody you trust, whether it’s a spouse or a professional adviser, who will slow you down when you’re eager to do something that may be wrong for you.
The topic of risk is too big to cover adequately in one sitting. But here are four “timeless truths” I have learned over the years.
ONE: Risk is normal; it shouldn’t surprise you. Any stock market that goes in only one direction for a prolonged period is abnormal and should be treated with suspicion.
TWO: Stock and bond markets are unpredictable in the short term. No matter when you are reading this, I’m quite confident that most of the market predictions that were made one year ago were so wide of the mark that they turned out to be of little help.
THREE: Over the past 200 years, the world’s stock markets have had a long-term upward trend, and I believe that trend is likely to continue. Capitalism appears to be gaining strength in the world, not losing it.
FOUR: The market’s immediate response to good news and bad news is almost always exaggerated. At times, many investors seem to believe that the entire future is wrapped up in the headlines of the day. But in fact, the best response to short-term problems and uncertainties is usually to ignore them.
So how do you know whether or not you are taking too much emotional risk? To get a handle on this, ask yourself these three questions:
- Have I lost sleep over my investments?
- Do I feel a compulsion (not just curiosity) to follow the financial news and check prices daily or weekly?
- Does the financial news make me worry about my future?
If you answer yes to even one of those questions, you probably have taken on too much risk.
You can hire professionals to allocate your assets, rebalance your portfolio, minimize your taxes and expenses and perform most of the other tasks that make up good investment practice. But you are the one who must deal with the emotional side of risk. It’s a job you can’t delegate.
Here’s some quick advice for finding the right level of risk.
Don’t take too much. Remember that if you lose 50% of your portfolio you will need a 100% gain to get back to your starting point. You can’t achieve any return unless you stick with the program that produces that return — and you can’t stick with a program if it scares you out of your pants and out of your investments.
Don’t take too little risk. If all your money’s in the bank or in T-bills, inflation will erode your purchasing power over time.
In the long run, moderation will serve you better than either too much ambition or too much caution.
If you don’t know how to make an allocation choice, start with half your portfolio in equities and half in bond funds. This might be too conservative, especially if you’re young. It might be too aggressive, especially if you have barely enough money to meet your needs.
But if your equity allocation is within 10 percentage points of 50% in either direction, you aren’t likely to go too far astray.
To hear a reading of the chapter on which this article is based, check out my podcast “How much risk will you take?”
And for some guidelines on how to be a better investor, check out this article.
Richard Buck contributed to this article.