What’s the biggest risk to your long-term portfolio today? Think about the headlines in the last few months. Is it trade tension? A global slowdown? Political gridlock?
While these events affect markets in the short-term, history tells us that the real risk is not any of those things, or any other headline around the corner. History shows that the largest threat to our own portfolio lies within each of us, and is often hard to control – it’s our own emotions. In other words, it’s not the headlines themselves; it’s our response to those headlines that can cause the greatest impact.
There’s a detailed study that is published every year by a company called Dalbar, which analyzes the typical investor behavior and compares that return to the overall market performance. According to Dalbar, the average investor significantly underperformed nearly every asset class over the 20-year period from 1998-20171. While the S&P 500 index averaged a 7.2% return over this period, the average 100% stock investor earned only 2.6%, which is so bad that they just beat inflation at 2.1% per year. Even a simple 60% stock, 40% bond portfolio beat the average 100% stock by 3.8% per year. That’s a 60% smaller return, for nearly double the risk!
Source: 1 and 3.
So what is causing such a difference in what investors are earning versus how the market is performing? The answer is simply that investors buy and sell stocks when they shouldn’t be. Investors tend to buy more when the market is at an all-time high, when “things are great” and volatility is low, and sell after the market declines. Dalbar’s research shows that psychological factors account for the majority of the shortfall experienced by the average investor. In other words, because many investors use emotions like fear and greed to drive their investment decisions, they often miss out on return.
Investors cannot afford to miss any “best day” returns because they sold their investments and sat on the sidelines.
We know that market declines and upswings can come without warning and are often swift. 20% market declines are often followed by full recovery within a few months to a year, and often times the best days in the markets come immediately following the worst. During the Great Recession in 2008, we experienced 8 of the best 20 S&P 500 return days from all of 1998 to 20172. Over the same time period, an investor that missed out on just 10 of the best daily returns of the S&P 500 index reduced their returns by almost 50%2.
We believe that the best weapon investors have in their arsenal to combat emotional risk is to have a plan, and to have someone to hold them accountable to that plan. That’s what we all do what we do at Sterling! We help you make a plan before fear and greed set in so that you’re better tuned to recognizing your emotions, and more likely to stay the course.
If emotions do take over, we are here to listen to you, walk you through your plan, show you how we’ve prepared for volatility, and to help you evaluate if it’s time to make a change. Know that it’s completely normal to feel afraid when the markets sink – it happens to every one of us.
In the end, we’re all just human.
- JPMorgan Asset Management, citing Dalbar Inc. Average asset allocation investor returns is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund sales, redemptions, and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/17 to match Dalbar’s most recent analysis.
- Morningstar Direct, as of 12/31/17. For illustrative purposes only and is not intended as investment advice. Past performance does not guarantee future results.
- Chart courtesy of JPMorgan Asset Management, citing Dalbar Inc. Indicies used are as follows: REITS: NAREIT Equity REIT Index, EAFE: MSCI EAFE, Oil: WTI Index, Bonds: Bloomberg Barclays U.S. Aggregate Index, Homes: median sale price of existing single-family homes, Gold: USD/troy oz., Inflatoin: CPI, 60/40: A balanced portfolio with 60% invested in S&P 500 Index and 40% invested in high-quality U.S. fixed income, represented by the Bloomberg Barclays U.S. Aggregate Index. The portfolio is rebalanced annually.
- Image courtesy of Carl Richards at Behavior Gap.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. Asset allocation, which is driven by complex mathematical models, should not be confused with the much similar concept of diversification. A diversified portfolio does not assure a profit or protect against loss in a declining market. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.