Image Credit: Christophe Vorlet
By Jason Zweig | 11:32 am ET Aug. 14, 2015
With China’s currency crumbling, oil prices collapsing and the U.S. stock market brushing its low for the year earlier this past week, you shouldn’t panic. You should, however, make sure you won’t join in if other investors panic.
Barely seven years after the financial crisis, it already feels like a distant memory—and rosier than it was. Test your own recollection of the bear market: Do you remember correctly that between October 2007 and March 2009, the U.S. stock market dropped in price by 57%?
If you think stocks can’t fall by at least 50% again, you are wrong. If you think you (or anybody else) can know exactly when that will happen, you are crazy. And if you think you won’t overreact when it does, you had better test that belief now—before it is too late to find out you were kidding yourself.
Allan Roth, a financial planner at Wealth Logic in Colorado Springs, Colo., says he recently met with three new clients, each holding between $8 million and $30 million in cash—all in bank or brokerage money-market accounts earning as little as 0.01% annually. Most of that cash isn’t even protected against loss by the Federal Deposit Insurance Corp., since the balances far exceed the government agency’s limits for coverage (generally $250,000 per depositor).
These clients, says Mr. Roth, dumped most of their stock holdings in 2008 and 2009 and never got back in. Only this year, with stocks again near record highs, did they finally get tempted to buy again.
Several studies have analyzed the toll that such performance chasing takes. Over the long run, it reduces returns by an average of approximately 1.5 percentage points annually. In a world in which, after inflation, even an average long-term return of 4% annually might be hard to achieve, your own performance chasing could take a bigger bite out of your returns than anything else.
So Mr. Roth has these clients buying certificates of deposit from many different banks, slicing the sums into small enough pieces for Uncle Sam to insure their money while often raising their yield above 2%. And they are tip-toeing back into broadly diversified bond and stock index funds, automatically buying a fixed amount every month for years to come. That, he says, “harnesses inertia, the most powerful force in the universe.”
Many such investors could benefit from an imaginative exercise that Gary Klein calls a “pre-mortem.” Mr. Klein is senior scientist at MacroCognition, a firm in Washington, D.C., that works with companies and government agencies to improve their decision making. In a pre-mortem, you take a disastrous failure as a given, then try to explain how it happened.
Imagine that markets have crashed, your portfolio’s value has fallen by 50% overall and some of your holdings have lost 90% or more. What outside forces caused it? What beliefs did you hold that turned out to be wrong?
“You’re probably not going to predict exactly what will wreck your portfolio,” says Mr. Klein, “but you will be able to imagine the kinds of things that could happen.”
Try this procedure with your financial adviser. If he resists, emphasize that you’re not trying to find fault and that “this is a difficult exercise that takes a lot of imagination and experience,” suggests Mr. Klein. “You can say, ‘This is another way to show me how smart you are.’”
Mr. Klein suggests taking no more than two minutes to write down as many reasons for failure as you can think of. The time pressure “shakes people up and helps them stop censoring themselves,” he says. Pre-mortems work best in groups, he adds, because “other people will have different mental models of what could go wrong.”
Each person should be able to come up with at least a couple of plausible reasons for failure. Compare notes, then discuss what, if anything, you should do to minimize the damage. If you have too much money riding on any one investment or strategy, set up a program to inch automatically out of it over time. Check your account statements from 2008 and 2009 to see whether you were as steadfast as you remember; if not, you should start trimming your stockholdings now, before another bear market scares you into slashing them.
And if your adviser refuses outright to help with a pre-mortem, you may be dealing with someone who is “dangerously arrogant or unable to deal with futures that don’t unfold the way he’s expecting,” says Mr. Klein—in which case you might consider looking for another adviser.
Source: The Wall Street Journal