Editor’s note: The market meltdown in early August has put many investors on edge. This excerpt from Dan Solin’s book “Wealthier” offer some suggestions to communicate to clients. Read another excerpt from his book here.
Just because you believe it’s necessary to look at your portfolio, that doesn’t mean you should make any changes, particularly when those decisions are likely to be influenced by emotions like fear.
Stoics believe a critical component of managing fear is recognizing factors outside our control. Stoics don’t spend time focusing on those factors. Instead, they focus on what’s within their control, like “thoughts, beliefs and actions.”
You can’t control a decline in the value of your investments, but you can control how you deal with it.
Your strategy should be to stay the course and resist the temptation to bounce in and out of the stock market. As stated by Vanguard founder John Bogle, “Don’t do something, stand there.”
If you invested in the S&P 500 index fund and missed the 10 best days in the market from 1993–2011, your returns would have been diminished by 54% over being invested during that entire period. So, you can understand why attempting to time the market by bouncing in and out is so risky.
Good Year? Bad Year?
Let’s take 2022, which was a bad year for both the stock and bond markets — a perfect storm for investors who relied on the bond portion of their portfolio to mitigate losses when stocks tanked. The ACWI, the all-world stock ETF, lost 18.37% of its value. SHY, the bond ETF, lost 3.88% of its value.
Suppose your portfolio was in a 60% (ACWI) and 40% (SHY) asset allocation. Your portfolio lost 12.57% of its value. That’s a big hit. If your portfolio was worth $100,000 at the start of 2022, it ended the year down by $12,570.
Bad year, right?
Not necessarily. It depends on your metric for success.
Realized vs Unrealized Losses
There’s a critical difference between a realized and an unrealized loss. A realized loss occurs when you lock in a loss by selling an investment for less than you paid. An unrealized loss is just on paper because you still hold the investment.
if you didn’t sell the ETFs you held in 2022, you had only unrealized losses. If you sold, you converted them into actual losses.
When you don’t respond to market volatility by taking action, you don’t convert unrealized losses into realized ones. You trust the market to recover your losses over time.
We don’t know what will happen, but history tells us the market goes up over the long term. What you do — or better, don’t do — in the short-term matters.
If our hypothetical investor was asked at the end of 2022 whether it was a good or bad year, the response should be:
“It was a good year. Although the stock and bond market was down, I didn’t convert unrealized losses into realized ones. I engaged in masterly inactivity. I continued to invest and took advantage of lower prices. When the markets recover, I will be well positioned to recover my losses and start on the path to positive earnings over the long term.”
Suppose you want to emulate the experience of this investor. You’ll watch your portfolio decline. You’ll be inundated with misinformation by the financial media and the securities industry. They want you to “take action.”
Here are some subconscious feelings you may experience pushing you to act contrary to your best interest.
Recency Bias: We overreact to recent experiences. When the market tanks, it isn’t easy to envision a recovery. Instead, we catastrophize and believe further declines are more likely, even though the opposite may be true.
Herding Behavior: We are inclined to follow others and imitate their behavior rather than act objectively and rationally. If we believe others are selling in a down market, we may be influenced to follow suit.
Cortisol Increase: When we see the value of our portfolio decline, we feel understandably stressed, as indicated by higher cortisol levels in the body. One study of London traders found that increased stress levels made them more cautious rather than more objective. If they acted rationally, they might have considered taking more risk when the markets crashed.
Confirmation Bias: We favor information that confirms preexisting beliefs. Confirmation bias may cause us to overweight negative information about further market declines instead of objectively considering data about the long-term history of the market. This bias can cause us to “do something” when the prudent course would be to “do nothing.”
If you are interested in exploring this area further, I highly recommend Thinking, Fast and Slow by Daniel Kahneman. It discusses cognitive biases in depth and explores the two conflicting ways we think about issues: intuitive and deliberate.
If you engage in “masterly inactivity” instead of overreacting every time the market pulls back, you can embrace the prospect of converting unrealized market losses into future gains.
Dan Solin coaches evidence-based financial advisors on how to convert more prospects into clients. His digital marketing firm is a leading provider of AI consulting, SEO, website design, branding, content marketing, and video production services to financial advisors worldwide. This excerpt is reprinted with his permission from his new book, “Wealthier, The Investing Field Guide for Millennials,” published in April 2024. The U.S. version is now available on Amazon in both English and Spanish, and a Canadian version will be published this fall.
Dan Solin coaches evidence-based financial advisors on how to convert more prospects into clients. His digital marketing firm is a leading provider of AI consulting, SEO, website design, branding, content marketing, and video production services to financial advisors worldwide. This excerpt is reprinted with his permission from his new book, “Wealthier, The Investing Field Guide for Millennials,” published in April 2024. The U.S. version is now available on Amazon in both English and Spanish, and a Canadian version will be published this fall.