These are the times that test investor’s souls, or at least their tolerance for risk. If you invest in technology, biotech and other stocks that trade on NASDAQ, you’ve seen quite a bit of volatility this year.
What does the future hold?
More volatility, which means risk. In stock market terminology, risk is the chance that your investments will go up or down. The wider the swing, the greater the risk. That definition of risk deviates from investor psychology in one enormous detail. Most of us don’t consider it a big risk that our portfolio will increase in value more than expected. We consider that a blessing. We define risk only as the risk that our portfolios will go down, not up. Yet volatility swings both ways, and to get the greater returns on the upside, we have to tolerate the gut-wrenching dips on the downside.
Too much risk causes panic
If you take on more risk than you can stomach, you are likely to bail at the worst time, when your portfolio is way down and you have lost your courage. You’ll lock in losses in stocks and bonds and mutual funds that probably would have recovered, had you only given them time. So one of the most important things an investor can do is to figure out how much risk you can tolerate, and don’t indulge in investments that are riskier than you can tolerate.
In volatile times you overestimate risk
Your tolerance for risk shifts somewhat based on your recent experiences. Last month I flew cross-country not long after a spate of airplane crashes. Though I’m usually a confident traveler, on the first leg of the flight I was agitated at every bump and air pocket we hit. But on the return flight, I had acclimated once again to the ordinary ups and down of the air currents. That’s human nature – through our biology, we are intended to overestimate risk. When we encounter a frightening event, our bodies react, and when we encounter the event again, we are wary. That kept our ancestors out of the path of saber-toothed tigers. But because we are programmed to avoid pain, we have a distorted view of investment risks. Our instinct is to get out of harm’s way rather than to take a more appropriate long-term perspective.
It’s painful to lose
Most people feel the pain of losing much more than they experience the pleasure of winning. If you have the chance to participate in a coin toss where you’ll win $20 if it’s heads, and lose $10 if it’s tails, most people would take the bet. You’ve got a 50% chance to win, and the potential loss is minor. Experimenters have found that if they raise the stakes, most people shy away. Heads you win $20,000, and tails you lose $10,000 is perceived as much more risky, even though the odds are exactly the same.
Our mistakes stay with us
Did you ever make a bad decision? Of course, and I’ll bet you remember quite a few of them. As a matter of fact, most people remember their mistakes far longer than they remember the good decisions they made. That’s why people are inclined to hang onto losing investments, hoping they’ll come back to their purchase price. If they haven’t sold, they don’t have to face their mistake. That’s the premise for this classic story: On the way to the race track one gambler turns to the other and says, “I sure hope I break even today – I could use the money.”
Overconfidence is dangerous in boom times
In Lake Wobegon, says Garrison Keillor, all the children are above average. In a roomful of investors, most of them will characterize themselves as above average, and that can lead to excessive risk-taking. And when investments in general have been moving higher, many people become overconfident. They attribute their portfolio growth to their astute strategy rather than to the investment climate as a whole.
There’s a saying on Wall Street that in an up market, everyone’s a genius. Remember the stock market crash of 1929, when almost everyone was leveraging their way into the stock market. The crash was so devastating it ruined the economy for many years to come.
So where does that leave us today? Many investors vacillate between wanting to make a killing on tech stocks and worrying that the stock market is overvalued and due for a crash. When the market goes up, they lament that they don’t have enough invested, and when it corrects, they are upset they didn’t pull out sooner. It’s important to recognize that the market ebbs and flows just like the tides. At high tide, you can enjoy the surf, and at low tide, it’s time to relax and enjoy the beach. Here are three tips to weather these volatile times.
Remember why you invest
The greatest risk for most investors is not meeting their goals. The best way to overcome that risk is to consider their time horizon for investing. If you need money for a new home next month, or next year, the stock market is a risky place to invest. Certificates of deposit are far more appropriate, where your capital is guaranteed. But if you need money in twenty years for investment, certificates of deposit are the riskiest investment, and stocks are the most appropriate. Though there’s not guarantee of your principal, time will overcome the ups and downs of the market, and the rewards will outweigh the risks.
Maintain reasonable expectations
If you don’t expect too much, you’ll always be pleasantly surprised, my parents used to tell me. And that’s good investment advice as well. If you count on a continuing 20% investment return each year when you plan your retirement or your college savings, your plans will be scuttled by a down year. But if you count on a more reasonable 8% – 10% return for long-term investments, bad performance in some years can be offset with good performance in others, keeping your investment train on track.
Add money over time, not all at once
For most investors, it is less risky to invest smaller amounts of money, and add to the investments on a regular basis over time. That’s called “dollar-cost averaging” and in general it results in lower cost of investments and higher returns, as you buy the dips. This strategy also can help more timid investors get used to the ebb and flow of the market, allowing them to dip their toe into shallow waters before they take the plunge.