How To Know When To Get Out Of The Market

Originally published CNBCHas the market’s recent volatility worried you? Me too. It’s inevitable. Apparently, it’s how we’re wired. But better understanding that wiring can give us a clear decision-making framework to help us know if and when to get out of the market.

The field of behavioral finance has demonstrated that the pain we derive from market losses impacts us twice as much as the pleasure we feel from market gains. For this reason, investors are well served to name and address these emotions instead of setting them aside as they (unfortunately) have been taught.

We’ve all heard of the cost/benefit decision-making model, but “cost” and “benefit” are intellectual constructs too distant from the actual emotions that drive our decision-making. We need to address the gut—the “pain” and the “pleasure” associated with a tough decision. The following four-step model seeks to merge the head and the gut. And while it’s applicable in virtually any either/or scenario, let’s specifically address the decision to stay invested in the market or to move to cash:

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1) The pain of staying invested is that I could lose even more. This is an entirely realistic possibility. What’s more, the pain is compounded when subsequent headlines—or your investment account statements—goad you into thinking that you could’ve—should’ve—avoided this pain if only you’d gotten out sooner. When this realization strikes the broader investing collective, it’s called capitulation—the moment investors give up en masse—and it typically signals the beginning of the forthcoming recovery, even the next bull market.

2) The pleasure of moving to cash is that my worry is eliminated and I’m guaranteed not to lose any more. Undeniably, you’ll sleep better tonight. But.

3) The pain involved in moving to cash is that I may miss the upside, thereby eliminating my opportunity to recoup recent losses in the next market up move. We know this, but the recent pain of loss is a far more powerful emotion than the projected pleasure, however probable, of gains in the future. The pain in box number three is often dampened by the hope that you’ll be able to get back into the market on the way up, a gamble statistically proven to be in the neighborhood of hopeless.

4) The pleasure in staying invested is that I’m giving myself a better chance to achieve my financial goals in the long term—the whole reason I invested in market in the first place. The market historically has paid investors a premium over cash and bonds precisely because it requires you to endure times of volatility. Without volatility, we’d have no reason to expect higher long-term gains. And for most of us, without the higher long-term gains we expect from equities, we simply wouldn’t meet our financial goals.

Does this imply there is never a reason to sell your market positions following a decline? No. The above framework assumes that your portfolio is diversified. It also assumes your portfolio is appropriately balanced with the stabilizing force of conservative fixed income allocated according to your ability (time horizon) and willingness (intestinal fortitude) to take risk. If this is not the case, there may, indeed, be grounds for change.

For the sake of creating a clear illustration, this framework only address the two extreme options of “sticking with the plan” or bailing out. Of course, there is a vast middle, and if you find that a typical correction or frightening headline has provided real-time evidence that your risk tolerance is not as high as you previously thought, recalibrating your portfolio may be entirely appropriate. It is imperative, however, to remember that the degree to which you shift out of riskier assets and into more secure assets will send you back to box number three. You’ll have to consider how much lost ground you’ll be able to reclaim in the likely subsequent market advance.

Please don’t paint me as an unrepentant stock market cheerleader. I believe that most investors—and even, perhaps especially, financial advisors—don’t fully appreciate and consider the serious emotions associated with volatility in investing. For this reason, I believe most people default to portfolios that are likely too heavily tilted toward stocks. Furthermore, if you don’t need the expected higher returns of the stock market in order to reach your financial goals, I’m inclined to recommend surprisingly low allocations to market exposure. On more than one occasion, I’ve recommended portfolios with absolutely no equities [gasp] for clients who didn’t need the excess returns and clearly didn’t have the stomach for volatility.

But if you’re already in the market, and in a well-conceived portfolio, the decision to get out is one deserving careful consideration, employing both the heart and the mind.

I’m a speaker, author, wealth advisor and director of personal finance for Buckingham and the BAM Alliance. Connect with me on Twitter, Google+, and click HERE to receive my weekly post via email.

Why The Stock Market Is Volatile, Why Volatility Hurts, And What To Do About It

Originally in ForbesUnless you made a resolution not to read, listen to or watch the news in 2016, you’ve likely noticed that “the market” is off to a stumbling start. Indeed, one glance at the headlines, at least the ones that don’t involve the presidential election, quickly reveals that the market is having one of its worst starts to any new year. This is a dubious distinction, to be sure.

The factors involved appear similar to those credited for causing the extreme volatility we saw in the fall of 2015—slower growth in China, falling oil prices, geopolitical instability and the threat of bankruptcies in junk bonds. But the optimist’s case seems equally compelling—high-quality bonds (the only kind I recommend) are performing very well, falling oil prices are good for consumers, the Fed’s interest rate rise signals a strengthening U.S. economy and the most recent jobs report was positive.

An objective view of the market reminds us that on every trading day in history, there have been compelling cases to be made for both optimism and pessimism—for purchases or sales. (Remember that every single security transaction involves a buyer and a seller, each of whom believes he or she is getting the better end of the deal.)

Ultimately, there is only one sufficient answer to the question, “Why is the market so volatile?” The market exhibits volatility because that is its nature.

We expect to make more investing in bonds than in cash because bonds are more risky. We expect to make more investing in stocks than in bonds precisely because they force us to endure even more uncertainty, and this logic continues to extend through the various slices of the market we isolate for the purposes of diversification (like small and undervalued companies).

But most importantly, the willingness to endure volatility has tended to reward the disciplined investor, and often the greatest reward immediately follows the most significant times of market turmoil. The greatest folly, then, is in attempting to divine precisely when these times of volatility will begin and end. Whether motivated by fear or pride, it is the business of prognostication that hurts investors most.

Does this mean that inaction is the only course of action in these times? Certainly not. Losses can be harvested in taxable accounts and replaced with similar securities, an activity that may benefit you at tax time. And in all your accounts, you have the opportunity to follow Warren Buffett’s chief investment advice—to buy when other investors are fearful—through strategic rebalancing. Doing so positions you to make the very most of the next market move upward.

I recently saw Jim Cramer, perhaps the face of market prognostication, confess, “I need a little perspective. We’re a little caught up here in the short term.” There is a reason that Mr. Cramer—and at times, you and I—get stuck in the short term. And it can be explained by behavioral science. We innately over-value losses and pain while under-weighting gains and joy, in money and life (explained in part by the “endowment effect”). And at the same time, we also over-weight what has happened most recently while under-valuing the more likely, long-term outcome (known as “recency bias”). Therefore, as you can imagine, recent losses are a powerful psychological duo that can even lead to clinical depression (a topic that my colleague, Larry Swedroe, recently wrote on).

The fundamental truth, and what I believe to be the antidote for this downward spiraling, is that we don’t invest in our portfolios for today, this month or even this year—but for decades in the future. Therefore, the unavoidable intermittent downside, like that which we’ve experienced in the first weeks of 2016, does not result in losses, per se, but merely declines.

This does not suggest, of course, that you must have a portfolio invested solely in large U.S. companies and then hold on with a white-knuckle grip while the market joyrides. Virtually every portfolio should include conservative fixed income and any equity exposure should be well diversified. And because human nature causes us to suffer market losses more deeply than we enjoy market gains, it’s prudent to err on the side of conservatism in portfolio construction. Furthermore, we should not be blinded by recency bias, either through over-optimism in good times or unfounded pessimism in bad times.

But once we have completed the process of portfolio construction, appropriately balanced in accordance with our ability and willingness to endure risk, it is imperative that we maintain discipline in volatile times. Indeed, the only way the market rewards us is if we’re willing to tolerate its eccentricities.

The Market Volatility Survival Tool: True Grit

Originally in ForbesIs recent stock market volatility bugging you?

True Grit

Do you wince with every headline announcing Greece’s demise, China’s bubble(s), the Federal Reserve’s indecision or the Dow’s down day?

Do you sneak a peak at your portfolio’s performance more than quarterly (or perhaps even annually)?

Does market volatility tempt you to question your investment strategy, even if it’s well thought out and carefully implemented?

Does it weaken your resolve to resist the sky-is-falling siren song heard so frequently in the financial media, or the sales pitch du jour?

Having the right investment strategy is important—really important—and surely contributes to long-term success in building wealth. But no matter how superlative your strategy, it’s your willingness to stick with it that ultimately will help you meet your financial goals.

Short-Term Memory Threatens Long-Term Success

When it comes to investing, rely on long-term wisdom

Originally published CNBCWhen it comes to the market’s peaks and troughs, investors often don’t react as rationally as they might think. In fact, in times of extreme volatility or poor performance, emotions threaten to commandeer our common sense and warp our memory.

Don't Forget --- Image by © Royalty-Free/Corbis

It’s called “recency bias.”

What the heck is recency bias?

Recency bias is basically the tendency to think that trends and patterns we observe in the recent past will continue in the future.

It causes us to unhelpfully overweight our most recent memories and experiences when making investment decisions. We expect that an event is more likely to happen next because it just occurred, or less likely to happen because it hasn’t occurred for some time.

This bias can be a particular problem for investors in financial markets, where mindful forgetfulness amid an around-the-clock media machine is more important today than ever before.

Try thinking about it this way. In the high-visibility and media-saturated arena of pro sports, every gifted athlete knows that the key to success can be found in two short words: “next play.”

Does Greece Really Matter?

The Bigger Picture for You and Your Portfolio

Originally in Forbes“Greece is a tiny player in global capital markets. Its default is 100% certain,” says Larry Swedroe, Director of Research for The BAM ALLIANCE and the author of 14 books on investing, including his most recent, The Incredible Shrinking Alpha, co-authored with Andrew Berkin.

“The only question is how much and what they default on,” Swedroe continues. “But with a GNP that is similar to Rhode Island’s, Greece’s default should have little to no impact on the world’s economy, at least not directly.”

So why is everyone so worried?

Greek crisis

Because raging forest fires are kindled from a single, tiny spark. “Greece’s default could trigger a broader contagion, like a run on Portuguese banks or a lack of confidence in the ECU, that may have wider ranging implications for larger economies,” says Swedroe, my colleague.

The Disciplined Investor’s Worst Enemy: Tracking Error

Originally in ForbesLast year was a tough one for disciplined investors. Disciplined investors know that diversification is a key element of successful portfolio management. But investors who stayed the course and remained diversified were punished for it in 2014, at least in the short term.

Disciplined investors will continue to be taunted over the coming weeks and months by headlines touting the success of “the market” in 2014. “Which market is that?” many of them will ask.

Head in Hands

Well, “the market” we hear about most often is the Dow Jones Industrial Average, which represents only 30 of the largest U.S. companies trading on the New York Stock Exchange. A slightly broader barometer of “the market” is the S&P 500 index, a benchmark tracking 500 of the largest U.S. stocks. In this case, “the market” could more accurately be translated as “the U.S. large-cap stock market.”

The Real Danger In Overstating Returns (Like PIMCO)

Originally in ForbesAs if PIMCO needed any more bad press, The Wall Street Journal reported this week that the Securities and Exchange Commission is investigating whether the bond giant “artificially boosted the returns of a popular fund aimed at small investors.” While we should all be attentive to the results of this probe—because I’d bet my lunch money that its implications will be felt beyond just PIMCO—there is an even deeper issue to consider. And this issue has a more direct impact on our individual portfolios and money management choices. The real danger in overstating returns, and indeed the root of most financial missteps, is self-deception.

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“How’s your portfolio?”

Who among us wants to feel like a failure? We’ll generally avoid experiencing this sensation at all costs. So, absent conspicuous success, we permit ourselves to believe that we’ve at least not failed, frequently through self-deception.

The Top 10 Places Your Next Dollar Should Go

Originally in ForbesThere is no shortage of receptacles clamoring for your money each day. No matter how much money you have or make, it could never keep up with all the seemingly urgent invitations to part with it.

TOP 10 DOLLAR

Separating true financial priorities from flash impulses is an increasing challenge, even when you’re trying to do the right thing with your moola — like saving for the future, insuring against catastrophic risks and otherwise improving your financial standing. And while every individual and household is in some way unique, the following list of financial priorities for your next available dollar is a reliable guide for most.

Once you’ve spent the money necessary to cover your fixed and variable living expenses (and yes, I realize that’s no easy task for many) consider spending your additional dollars in this order: 

My bad! I was wrong about rising rates and bonds

Originally published CNBC

“I was wrong.”

There are few words strung together that possess such power to free us. In less than a second, we’re able to reconcile the inconsistency between our previous conviction and the apparent truth. Humbling, yes, but also strangely euphoric.

Well, I’ve earned the opportunity to claim said euphoria, as I must confess that I had bought into the most prevalent myth du jour surrounding bond investing. You’ll forgive me, I hope, because this misconception—like all of the most powerful ones—is especially deceptive because it’s grounded in half-truth.

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Let’s be quite clear: Rising rates simply do not guarantee negative bond returns.

Why Beating The Market Is An Uphill Skate

Originally in ForbesIt is absolutely possible to beat the market, just as I’m sure it’s possible that someone could climb Mt. Everest in a pair of roller skates.

It is so improbable, however, that it’s rendered a fruitless, if not counterproductive, pursuit.

After 16 years in the financial industry and seeing countless great investors eventually humbled by market forces they could not control, I’ve finally relinquished my skates.

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