What is the number one rule in investing?
“Buy low, sell high?”
Or, is it billionaire Warren Buffet’s number one rule, “Never lose money?"
While those are both sage pieces of advice, my number one rule in investing is to never interrupt compounding unnecessarily.
I’ve found that compounding of wealth is usually interrupted in one of three ways:
1. Bad behavior
2. Bad planning
3. Bad luck
Let’s start with #3. Bad luck can be somewhat mitigated by building a strong defensive strategy. That includes maintaining an adequate emergency fund and implementation of the right types and amounts of insurance – liability, home, auto, health, life, and disability. However, it may be impossible to fully insulate your capital from all of life’s curveballs, as you may need access to your money one day due to a major event outside of your control.
Number 2 – bad planning - means voluntarily dipping into your portfolio prior to its expected time horizon for an unplanned (perhaps unnecessary) expense. This can be mitigated through the implementation of a goals-based financial plan that is updated regularly. The plan maximizes the potential of compounding by assigning each dollar a specific job and time horizon.
As we get to number 1 on the list, we find something that’s absolutely within the complete control of every investor: bad behavior. So why is this still a notable problem that derails the power of compounding, again and again?
Psychological and behavioral biases may cause investors to make decisions with their portfolio that have a negative impact on their long-term investment success.
Basically, human beings are often our own worst enemies when it comes to investing.
Understanding Behavioral Finance
Behavioral Finance is the study of psychological influences and biases that directly affect decisions around money. This phenomenon explains why markets often move erratically, based not on objective data but on the actions of participants who aren’t always acting rationally.
These influences can actually drive investors to make decisions that are contrary to their best interest.
Some common biases include:
Confirmation Bias – accepting information that confirms an already-held belief while ignoring information that contradicts it.
Examples: searching out news reports that support your opinion that markets are set to go up/down. Or, if this candidate or that candidate wins the election, the economy will tank.
Loss Aversion- placing a greater weight on the concern for losses than the pleasure derived from market gains.
Example: studies have shown that investors feel the effect of losses TWICE as much as they enjoy the satisfaction of gains.
Familiarity Bias- the tendency of investors to only buy what they know and are comfortable with, at the exclusion of other alternatives.
Example: a US based investor may neglect quality international stocks in their portfolios. (By the way, this is also an issue with investors in Australia, Japan, Europe, and the UK.)
Anchoring Bias- becoming tied to a readily available reference point when making an investment decision.
Example: judging your portfolio allocation and performance based on its most recent high-water mark.
Recency Bias- over-extrapolating the recent past or present into the future.
Example: assuming a current run-up or downturn in stocks will persist forever.
These biases in human behavior are not likely to go away anytime soon. They’ve been ingrained in us since early humans survived by hunting and foraging for food, all-the-while mightily trying to avoid becoming food for something else!
To that point, Jason Zweig of the Wall Street Journal writes1:
“In the formative dawn of human history, someone who kept failing to predict where food could be found would have starved to death, while anyone who correctly gambled on finding an unlikely cache of food would have been a hero. Meanwhile, someone who underestimated a risk would have become a quick snack for a wild carnivore.”
We avoided danger wherever possible by eliciting the amygdala portion of our brains, alerting us to fight-or-flight. Today, this same part of the brain shouts at us to sell stocks and hide when they drop sharply, or, conversely, screams at us to double-down when the market is running hot.
Consider how these forces can destroy compounding by observing the chart below:
In this hypothetical example from Morningstar, prior to the financial crisis, an investor comes into 2007 with $100,000 invested.
In the first scenario (light blue), the investor remains invested through the challenging 2008-2009 Great Recession and beyond. At the low point, this investor sees his/her investment cut in half. The market turns upward in March 2009 and by the end of 2019, the account balance is $299,780.
In the second scenario (dark blue), the investor gives into the fear and anxiety of the times and sells his/her positions at the bottom in March of 2009. (Having lived through this myself, I can tell you that this scenario was a common at the time.)
The investor then waits for a year to let the dust settle before redeploying cash back into the market. The account balance at the end of 2019 is $195, 315.
Therefore, interrupted compounding cost this investor more than $100,000.
In the final scenario (green), the investor sells at the bottom in March of 2009. But, because of the financial pain and trauma, still has not returned to the market. Bad behavior and the permanent interruption in compounding have cost this investor almost $250,000 in lost opportunity.
I Don’t Have a Problem, You Have a Problem
The most interesting thing about biases is that we rarely recognize them in ourselves. It’s human nature to believe these influences only affect others. We’re all especially adept at coaching and critiquing…someone else.
In fact, research suggests that a majority of investors consider themselves better than average at making decisions. Mathematically, we know this can’t be true.
Vanguard’s 2019 Advisor Alpha2 study quantified the value a financial advisor adds to client outcomes. They analyzed seven areas in wealth management: asset allocation, cost-effective implementation, rebalancing, behavioral coaching, asset location, spending strategy, and total-return investing versus income investing.
They concluded that behavioral coaching is the most impactful thing an advisor can do. Their research found that on average, behavioral coaching added 150 basis points (1.5% per year) of return.
When emotions are running high during volatile markets, it can be tempting to make a costly move. Receiving guidance from a trusted advisor can save you from panic selling and abandoning your long-term financial plan.
Morningstar released a recent study titled, “The Value of Advice. What Investors Think, What Advisors Think, and How Everyone Can Get on the Same Page”3. They surveyed 693 individual investors and asked them to rank a set of common attributes in order of importance. They then surveyed 161 advisors asking them to rank the attributes they felt investors found most valuable.
From the study (emphasis mine):
“Advisors and investors both place “Helps me reach my financial goals” in their top three most valuable attributes, but the other top attributes display different priorities. Investors valued the technical side of financial advice more than other benefits of advice—especially in the behavioral realm. “Helps me stay in control of my emotions,” for example, is ranked last by investors even though research suggests that cognitive biases and other behavioral obstacles often inhibit investors from making sound financial decisions, especially when their emotions are running high. Behavioral coaching is one solution for common behavioral mistakes (such as panic selling in a market downturn) but it was all but ignored by the investors who took our survey.”
The key is to acknowledge that these biases exist, admit that you too are prone to them, and then, relentlessly focus on your long-term goals and financial plan.
The Path Forward
Recent evidence suggests that giving investors a specific target can improve behavior.
By following fund flows into and out of the various investments, Morningstar’s 2020 Mind the Gap4 study measured the investment results investors achieved relative to the performance of the underlying investments they owned. The difference between the two is commonly referred to as the behavior gap5.
Over the recent 10-year period ending 12/31/2019, more volatile asset classes had more poorly timed fund flows. Investor loaded up when it felt good and sold when things got rocky. For example, investors underperformed their own investments by more than 1% per year in International Stocks and Sector Equity. Even pedestrian municipal bonds saw a gap of almost 1% per year.
On the plus side, US Equity investors outperformed their investments just by staying the course and continuing to contribute during downturns. The caution here is that US Equity has been the best performing asset class over the last ten years. Even with several sharp downturns, the asset class rebounded consistently over that period.
Probably the best news is in the Allocation category, which had a positive gap of .40%. An allocation fund is an all-in-one, ready-made diversified portfolio. Allocation funds such as Target Date Retirement Funds have been widely adopted in many corporate retirement plans. These options give investors a diversified portfolio with a risk profile matched to their desired retirement date.
As an investor approaches retirement, the fund automatically reduces stock exposure and increases exposure to bonds and cash. The evidence suggests that investors in their retirement plans may be “setting it and forgetting it.”
They are continuing to make contributions, even during downturns, and avoid selling these funds based on short-term market fluctuations. The structure and name of these funds appear to be providing a solid behavioral guidance that focuses investors on their desired outcome.
We aren’t necessarily doomed to fail because of our ancient brains. Overcoming behavioral biases and avoiding the interruption of compounding can be as simple as 1,2,3,4.
1) Acknowledge that you are human and have inherent biases built into your hard wiring. This will allow you to be more aware when the fight-or-flight response hits.
2) Focus on the long-term. Remind yourself of the reasons you put yourself through the normal ups and downs of an investment portfolio. You’re likely investing to grow wealth, preserve purchasing power throughout life, and meet well-defined financial goals.
3) Assess your tolerance for risk regularly. Be prepared for regular downturns by understanding how your portfolio may have performed during previous market cycles. Assessing how assets have declined and recovered in the past can provide more confidence in the present.
4) Reach out to us if you’re ever feeling uneasy. We aim to be proactive in client outreach through blog posts, emails, phone calls, and review meetings. Everyone needs more personal counsel from time to time, and we’re here for you.
After all, the best athletes in the world have a coach, so the best investors should, too!
2. “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”, Vanguard Research, February 2019
3. “The Value of Advice. What Investors Think, What Advisors Think, and How Everyone Can Get on the Same Page”, Morningstar Investment Research, 2019
4. “Mind the Gap 2020”, Morningstar Manager Research, August 2020
5. The study authors do point out that it may be too simplistic to associate the entire gap in returns to ill-timed investment decisions. But they are also quick to point out that an extended bull market likely contributed to a narrower gap over this 10-year period than prior periods.