Tolstoy said, “Happy families are all alike; every unhappy family is unhappy in its own way.” As investors, the opposite could be said. There are a number of ways to be a happy investor, and a number of paths to success.
However, all unhappy investors tend to have one thing in common: they overreact.
There are a number of ways to overreact — being overly confident, being overly fearful, trading too much, or trading too little — but the bottom line is that if you are overreacting in any direction, you are not following a plan. You’re not being proactive; you’re being reactive.
What tends to trigger you to react when it comes to investments? Be honest. Is it factors within your control (such as increasing your retirement contributions when you get a raise) or factors outside your control (such as the unpredictable gyrations of the S&P 500 or individual stocks)? Many investors will say they have a certain tolerance for risk. But when they see their account go down by 10 percent, they may feel panicked and want to stray from their stated investment allocation.
Being honest with yourself and knowing when you are likely to be tempted to stray from your strategy will help you to know what to do when these situations arise.
Here are a few ways to avoid overreacting with your portfolio:
— Invest comfortably
— Work with a trusted advisor
— Manage your expectations
— Limit how often you check your balances
— Think for the long term.
— Understand corrections and bear markets
Implement an allocation suitable for you. This is probably the most important factor in avoiding overreacting to market movements. For example, if you have a low tolerance to market movements, or are an investor with a shorter time horizon who depends on your portfolio for income, having large percentages of your portfolio invested in equities will cause you heartburn.
An investor sensitive to volatility should make sure he or she has a portion of the portfolio that is insulated from the market. This would involve cash reserves for everyday living expenses and fixed income to provide a buffer from equity swings. Equities are still an important factor for the majority of portfolios, but some investors may not be able to tolerate as much exposure to equities as others. By designing your portfolio to suit your individual needs, you can rest easy when stock markets have wilder movements knowing that the parts of your portfolio you depend on are not affected.
Work with a trusted advisor. A good advisor should be able to understand your needs and tolerance for risk and create a portfolio allocation accordingly. Working with an advisor also has two other distinct benefits in relation to market movements.
Your advisor should be able to soothe your nerves, explain market movements and “talk you off the ledge” if you find yourself spooked by bad markets, or feeling overconfident in strong markets and about to make a big, reactive change to your portfolio in response.
Having an advisor manage your portfolio means you have a sounding board for your ideas and goals, and someone who can tell you whether certain choices will bring you closer or farther away from your goals.
Choose an advisor who is proactive and designs your portfolio based on your specific financial situation, rather than being reactive to market movements, or based on predictions about market movements or interest rates.
Manage your expectations. Use your advisor to educate you about the expected movements of your portfolio. For example, if you have a very aggressive portfolio, you must expect wilder swings when markets move.
Equally so, you should expect higher levels of long-term returns since risk and return are inextricably linked. Also, it is important to understand that if you have a low tolerance for risk, your returns to the upside will not be as high.
Limit how often you check your balances. Imagine if every day at 4 p.m. there was a market price for your home — and you logged on every single day to see if it had gone up or down. It would cause you great amounts of stress, but in the end, it wouldn’t mean anything at all unless you were actually planning to sell your house. Your invested assets should be viewed in the same manner.
As long as you are appropriately allocated, daily or weekly fluctuations should not be a concern unless you plan to sell.
This is a hard one to stick to if you are a nervous investor, but your stress levels will thank you for it. Intra-day and even intra-week price movements in equity markets can be difficult to stomach.
Keep a chart of markets’ long-term performance on hand. When markets correct, falling 10 percent or more from their recent highs, it can feel shocking and unnerving. But a visual chart can help to put these moves into perspective. When you stretch out a chart of the S&P 500 or the Dow Jones Industrial Average for even a few years, short-term dips pale into insignificance.
Knowing how to find market charts online to remind yourself that corrections and even bear markets are a normal, healthy part of how markets operate may help you stay calm when markets are not calm.
Keep statistics about corrections and bear markets on hand. Whether minor corrections or major selloffs, bear markets only represent 27 percent of the long-term experience in the stock market since 1872 (and this includes the Great Depression). And even with those bear markets included, the average annual return over that period has been 10.4 percent.
Even if you look at market history since 1945, there have been more than 850 months, of which only 90 have given us a 20 percent downturn or greater (around 10 percent of the time), all of which inevitably recovered and went to new highs. According to a study from the Capital Research and Management Company that examined the average frequency of market corrections from 1900-2010, a correction of 10 percent occurs about once a year on average. Corrections of 5 percent take place about three times per year.
Use these statistics to remind yourself that corrections and downturns, while uncomfortable, are normal and expected. Though the cause of volatility (positive and negative) might be different, the price movements themselves are not different. In an individual investor’s lifetime of about 80 years, he or she can expect to live through about 240 corrections (though of course, for a number of years the investor may be too young to have an investment account). Understanding how often these happen, and that they are a normal part of healthy market mechanics may help you stay the course as a long-term, diversified investor, and avoid over-reacting to excessive fear or euphoria.
It always helps to put today’s market events and today’s individual worries in a longer-term context. No matter how many gloom and doom headlines you read, in all likelihood today’s crises do not mark a new normal that require a drastic change to investment strategies. Do not allow short-term market events to derail your long-term path, and you’ll continue making progress to your goals.
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6 Ways to Fix an Incredibly Common Investing Mistake originally appeared on usnews.com