Don’t Let Fear Dictate Your Investment Decisions

Mar 2012

On March 9, 2009 the S&P 500 Index dropped to a low of 666. Three years later on March 9 the S&P Index closed at 1,371 — an increase of over 100%! Although the performance of the market has been impressive, many individual investors have not seen the benefit of the most recent bull market because it is hard to make money in the market when your money isn’t in the market. Case in point: In 2011 investors withdrew more than $130 billion from equity mutual funds according to a recent article. Since the March 2009 low there have only been two months which individual investors have put more money into stock funds than they have withdrawn. Despite the S&P 500 Index having its best two month start in more than 20 years and corporate profits recording double-digit gains, individual investors remain on the sidelines and trading volume is at a 15 year low. The question is why?

The answer is really quite simple: Many investors suffered substantial losses in 2008 and vowed never to be put in that position again. Rather than re-examining the role equities should play in their portfolio and looking at their asset allocation and risk tolerance these investors fled the market. Instead of looking at their long term goals these individuals allowed their emotions – their fear of losing money- to dominate their decision. The undeniable fact remains — those that stayed in the market and maintained a broad-based diversified portfolio recovered all (if not substantially all) of what they lost during the 2008 crash.

Unfortunately individuals have the uncanny habit of selling low and buying high. During the period 1991 to 2010, the annualized returns of key asset classes were as follows:
• S&P 500 Index – 7.7%
• Gold -7.2%,
• Bonds – 6.1 %
• Inflation – 2.4%.

Unfortunately, according to an analysis by Dalbar, Inc. a respected research firm, the average investor return during this same period was 2.6%! For most investors to achieve their financial and investment goals they must achieve returns that beat inflation. Exceeding the annualized return of inflation by .2% over 20 years hardly qualifies as a success.
One reason average investor returns are so poor is how they react to major events such as natural disasters or political events. Sometimes these events are predictable – sovereign default in Europe, surge in oil prices due to conflict in the Middle East. Other times the events are unpredictable such as natural disasters. Inevitably the market does drop (sometimes quite substantially) in response to these events. Whenever these “once in a lifetime events” occur these individuals think “this time is different” and sell their holdings thinking they can avoid a cataclysmic loss. However these events occur with regularity and are not “one time” events. Consider some recent invents:

• March 2011, Japan’s earthquake and Tsunami,
• August 8, 2011 – S&P downgrade of United States AAA credit rating
• 2010 market flash-crash
• 2010 BP Gulf of Mexico oil spill
• 2008 credit crisis/mortgage meltdown

Despite these significant losses, personal and financial, that resulted from each of these events, there are two common themes: 1) no one predicted these events, and 2) each event caused the substantial market losses. However, it is also important to realize that in some cases substantial market losses are followed with substantial gains. For example, the single greatest daily percent loss in the Dow Jones Industrial Average occurred on October 19, 1987 when the Dow dropped by 22.61% however on October 21, 1987 the Dow experienced its seventh best daily percent gain of 10.15%.

The reason average investor performance has been so poor is that rather than basing investment decisions based on long term goals they are based on emotion and fear. This is not an investment strategy. Whenever decisions of any kind are based on emotion rather than on reason it usually results in a poor decision. Only by maintaining a disciplined and thoughtful approach to investing during severe times of high anxiety can an individual investor achieves their financial goals.


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