A Tale of Two Decisions

| August 24, 2020 | 0 Comments

The stock market drop in February and March was the fastest drop of that magnitude on record. The recovery since late March has been equally breathtaking. In fact, many people we speak with are surprised that the broad stock market has completely recovered its losses for the year.

During turbulent markets like these, investors face a tough decision. Should they sell stock investments, wait for conditions to improve, and then “get back in” when things seem better? Or should they stay the course and ride out the volatility? It’s a very enticing concept – to be able to time when to get out and get back into the markets. The problem is that attempts to time the market are usually counterproductive. Academic research is crystal clear on this: there is little evidence that anyone can do this successfully AND consistently.

Part of the problem is the way we humans process information. One of the mental shortcuts that we’ve evolved with is called “Confirmation Bias.” This is the tendency to focus on information that confirms our beliefs or decisions while discounting or ignoring that which is contrary. Investors who are worried about the market will look for additional causes to be concerned, while those who are optimistic only see the good news. What this means is that once you’ve decided to get out of the market, it becomes harder to get back in. The following example may help illustrate this problem.

Back in March of this year, the markets were awash in bad news and reasons to be afraid. As coronavirus concerns becoming clearer, and the stock market was plunging, I was speaking with a lot of my clients. Two conversations in particular stick out in my mind. Both clients are retired and are relatively conservative investors with about 60 percent of their portfolios invested in bonds and 40 percent in stocks.

Conversation 1. We’ll call this client “Abe.” Abe was very concerned, as the S&P 500 Index had already dropped by about 25 percent by that time, and his portfolio was down by a little over 13 percent. Abe was worried about further downside and was thinking of selling stocks to reduce the risk. He was a little shocked when I advised him to make a completely different decision.

Rather than sell stocks in his portfolio, we would sell some of his bonds (at their high values) and use the proceeds to buy some more stocks at their distressed prices. I reminded him that this would not be a speculative move. Rather, this was part of the long-term strategy we had agreed to when we began working together. Whenever the proportion of stocks to bonds went out of balance, we would rebalance the portfolio to bring it back in line. That meant selling some of an asset that was riding high, and buying some that were low, as was especially true in March of this year. He ultimately agreed, and we sold some bonds and bought stocks.

The next few weeks were difficult for Abe. We had several conversations about the direction of the markets and the soundness of the long-term portfolio strategy. By the end of July, Abe’s portfolio had recovered completely and was positive for the year.

Conversation 2. At about the same time I spoke with Abe, another client (we’ll call him Ben) called me and asked me to sell all the investments in his portfolio. As with Abe, Ben wanted to reduce the risk of further downside. Unlike Abe, however, I wasn’t able to convince Ben to stick to the long-term plan. On March 23, we liquidated everything and purchased money market funds and CDs. It surely felt better to be sitting on cash and CDs for those weeks when the volatility continued, but Ben was focused on all the bad things happening around him, and not how the investment markets were reacting to events. As is so often is the case, the markets recovered long before it felt safe to invest. By the end of July, Ben’s portfolio was still 14 percent smaller than it began the year.

Developing a solid strategy ahead of time and sticking with it is one way to limit the impact of confirmation bias. By focusing on the long-term and staying disciplined in turbulent times, you can set yourself up for better results. It may be as simple as avoiding those mental traps that helped our ancestors survive in the wild, but which aren’t always well suited to successful investing.

This column is prepared by Rick Brooks, CFA®, CFP®. Rick is director/chief investment officer with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at brooks@bfadvisors.com. Brooks and his family live in Mission Hills.

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