Question

Scenario #1: Kenny is ready to implement the investment policy portion of his financial plan. After months of dragging his feet, he began by allocating into a well-diversified portfolio that his financial planner artfully crafted for him, across a myriad of asset classes. Days after he invested into his portfolio, in accordance with his long-term goals and risk profile, the stock market suffered a big drop. The economy wasn’t in peril, or even a recession, but the market just experienced a normal, run-of-the-mill “correction” that happens from time to time over the short-term. Even though Kenny’s portfolio only has about 50% of its assets in stocks, he is scared. He feels like he has just been through the ringer, and he is only a few weeks into his long-term plan! How could this be? His planner told him that there would be “days like this,” that his plan is built for the long-term, and it is inline with his goals and risk tolerance. Further, he told Kenny that he will only experience about half of the downside as the stock market itself (since half of his portfolio is out of the stock market), yet he still feels like he made a bad decision. He wants to sell everything at once, so he picks up the phone, screams at his planner, and forces him to sell everything that just went down. 1) What behavior/bias is present? 2) Why is this behavior detrimental? 3) What could have been done differently, or what could be done differently next time to avoid this result?

Answer 1

1. Investor fear here is characterized by an emotional bias. Emotional biases arise due to investor psychology and are often driven by underlying fear and greed.

2. This behavior is detrimental to rational investing because fear drives the investor to sell the assets at low prices during a downward market cycle, out of fear of incurring more losses. This kind of behavior is not based on rational decision making or understanding of the stock/market dynamics. It is spontaneous and may adversely impact the investor when the market takes an upward cycle and the stock prices stabilize/increase. Particularly, since the investor is looking at a long term investment, such periods of upward and downward market movements are unavoidable and it would not be prudent to act on every short term movement. Long term investment and wealth creation by designing a well-diversified portfolio of investments across asset classes should not be disturbed in sight of short term market movements.

3. The investor should avoid yielding to emotional biases and understand the cyclical natural of market movements to create wealth over a long horizon. Since the portfolio is well-diversified with 50% invested into stock markets and the remaining across other asset classes, a much wider window of time, spanning full market cycles, should be applied for portfolio re-optimization and computation of returns. If the investor is risk-averse and not ready to have short term dips in his portfolio as a result of market movements, he may focus on investing in less risky assets and accepting lower returns. This would be better for the overall returns for the investor rather than selling off stocks by incurring losses at market lows.