Hi kids. Nelson here. Today we’ve got a guest post from Rob Pivnick, who works for Goldman Sachs. This automatically makes him the smartest person who has ever visited this blog by a factor of ten. He wrote a book called What All Kids (and adults too) Should Know About . . . Saving & Investing. I haven’t read it, but Rob seems pretty smart. I’m sure it’s a good gift for your favorite millennial. Take it away, Rob.
It’s a tiger. Or maybe a lion or wolf. And it’s bearing its fangs. And growling a terrifyingly menacing growl that makes the hair on the back of your neck stiffen. Predator saliva is dripping from those fangs, perhaps mixed in with remains of its last hapless victim. You are a caveman or maybe a hunter from tens of thousands of years ago. Your life is at stake. What do you do? Fight or flight?
The hypothalamus in your brain is working overdrive with your nervous system and your adrenal-cortical system. You are sweating and trembling. Your hands are shaking. Muscles tense. Pupils dilate. Your body is processing the danger in lightning speed as your body tenses up and becomes more alert as it releases adrenaline into your bloodstream. Your heart rate and blood pressure increase. Your body actually shuts down non-essential systems (like digestive and immune) so you can more properly focus on the danger. Several dozens of hormones are released into your body that prepare you to deal with the threat. You must do something. Or you could die.
It is the same bodily response that occurs when you wake in the middle of the night to the crash of a window breaking in your home – a burglar. Do something.
And, surprisingly, a similar response occurs in your body when the stock market has a really bad day. Behavioral finance experts call it “myopic loss aversion” – it’s the “fight or flight” of the investor world. And it is what causes most investors to “do” something instead of making sound decisions to stick to their long term plan. Instead of fangs and growling, however, investors see their long term goals and dreams vanishing. Early retirement . . . gone. Vacation homes no longer a reality . . . just pictures in a magazine. College savings . . . vanished.
Behavioral Finance – Is Loss Aversion Thwarting Your Investing Results?
You see, investors feel more pain from losses than pleasure from gains, which causes them to take a very short term (myopic) view of the market. You may recall the feeling of nausea in your stomach the last time you checked your portfolio after a few days of huge losses. Take, for instance, the five or six trading days starting the second week of October. Volatility shot through the roof. Domestic equities fell over 7% from their September record highs. You had to “do” something about it, right? The result: most investors likely sold precisely when they should not, because they fear a big loss. It’s panic selling.
In 2008, a record was set for the most outflows of dollars from domestic equity funds because investors panicked (the market was, after all, dropping like a rock). What happened next? The market has been on an unprecedented climb since then, with returns reaching almost 200% from the market low. As of the date of this blog, it’s still climbing. And many investors missed out on that recovery.
Jump In and Out of Markets at Your Own Peril
The numbers don’t lie. Investors make emotional decisions that severely handicap their investment returns. The historical average market return is around 8.5%. But somehow the average investor’s return is only 3-5% (depending on the source) because they get caught up in media hype and fear. Rational thinking disappears in times of stress. If you lost sight of your long term goal and panic sold and missed just the ten best days in the market over the last twenty years, your annual return dropped to around 5.5%. If you were unlucky enough to miss the thirty best days, your return was less than 1%.
Best Investing Advice – Stick To Your Long Term Plan
But you have a long term plan so stick to it. If you check your portfolio after every down day in the market, you open yourself up to reacting to myopic loss aversion. And your reaction is irrational precisely because you have a long term plan that you are ignoring. You fear big losses. But stay the course and do not react to sharp market declines. Fight the tendency to “do” anything that deviates from your plan. And do yourself a favor, do not check your portfolio as often. Then you will put yourself in a position to have to “do” anything and you will not react to the volatility.
Oh, by the way, if you did panic and sell after the early October drop, you missed the market’s best weeklong gain in over two years immediately after (almost 5%). In total since the drop, the market has rung up over a 9% return. I hope you did not miss out.Rob Pivnick is an investor, entrepreneur, attorney, residential real estate investor and financial literacy advocate. Rob has both a law degree and an M.B.A. from SMU in Dallas, TX. He is a member of the board of directors of the Texas affiliate of the national Council on Economic Education. Professionally, Rob is in-house counsel for Goldman, Sachs and Co. and specializes in finance and real estate. Rob’s book, “What All Kids (and adults too) Should Know About Saving & Investing,” targets young adults/millennials with vocabulary words, fun facts, “Did you know?” sections, and 14 key takeaways. Statistics, charts and graphs from expert sources bolster the information. It aims to help students develop proper habits for saving and investing for long term. Not get rich quick. Chapters include budgeting, debt, setting goals, risk vs. reward, active v. passive strategies, diversification and more. Visit www.whatallkids.com for more information. Twitter: @RPivnick.