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Is your gut instinct causing financial Darwinism?

Is your gut instinct causing financial Darwinism?

| May 13, 2015
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Investing

"The very essence of instinct is that it's followed independently of reason." - Charles Darwin

The year was 2007. What a time to start a career centered on investing! Expectations were high, market indexes were higher and it seemed that making money was easy. Then the “Great Recession” hit and the S&P 500 plummeted -57%! To make matters worse, the housing market tanked and with it the average investor's attitude eroded with much of their wealth. We’ve met many who followed their gut instinct and got out of the market. The sad thing is that their gut instinct kicked in too late - after the market had fallen and many stayed out during the last 6 years of stock market growth. That's the problem with the gut, it's your emotions which are a reaction to what just happened, not what is going to happen.

Buy low, sell high. That’s how to make money in the stock market right? The problem is you have to be right twice and there are only so many times you can make a lucky guess. You need to be astute enough to determine when an investment is low enough to buy and again when it’s high enough to sell. What about bad investments that may not go any higher? When to cut your losses? Perhaps many of these questions are best left to the professionals... There is absolutely no rule of thumb here. 

How do professionals do it? For simplicity and illustrative purposes let’s take a top performing stock fund from my lineup. Many of you may have this in your portfolio. This fund has 98 stocks, 28 professional analysts and 4 portfolio managers on their team. Each analyst spends their career, day in day out working with a handful of stocks. For this team, covering roughly 4 stocks merits not only 40 hours a week but an entire career is devoted to them, what’s that tell us about stock picking? If it were easy, everyone would do it. Those who perform well put tremendous amounts of time and capital into each company they invest in. Even with all those resources, there's still no guarantee to perform well!

Financial Darwinism. Fear of loss is very powerful. It's been said that bear market loss (when the market falls more than 20%) is the psychological equivalent to investors of fleeing from a real bear. Funny thing being chased by a bear and following the gut instinct to run – the bear will chase and you will lose. I feel the same holds true in investing and the data is compelling. Below is one of my favorite data sets from JP Morgan.

**According to JP Morgan, from the height of the market in 2007 until the end of February 2015, retail investors (that’s you and me) dumped more than $661 billion out of US equity mutual funds and ETFs.  As of quarter end, the S&P 500 is up 205% from the bottom doubling, twice!  You tell me, has the investing public been rewarded for this mass exit? I'd liken it to the financial equivalent of lemmings following their herd instinct off a cliff.

What do you do?! Try and take out the emotions, ignore gut instinct, forget that nagging feeling to get in our out of the stock market. It all comes down to disciplined. This is where solid professional advice comes in handy. At Engage Advisors, LLC, our advice is to pick a financial planner who is educated, experienced, values aligned, and can be there for you when you need them most. Otherwise you and your family could be in big trouble.

How much can you lose? There are many risks that can be reduced at the portfolio level. Risk of total loss is one of the most important. By reducing risk in the portfolio and smoothing out volatility, it should be easier to remain disciplined. To help maintain this discipline, We’ve provided a list of ideas that we believe should help:
 

  • Utilize a healthy asset allocation.
  • Diversify, not just by security, but by geography, sector, strategy etc.
    • One caveat on diversification, over-diversification can mute returns just as much as under-diversification can amplify risk/loss.
  • Re-balance regularly, at least once a year.
  • Have a strategy consistent with your time horizon.

Moral of the story: Ignore the emotions, remain disciplined and avoid the financial Darwin award. We focused on stock analysis, portfolio construction, risk reduction and emotional response to loss. If you’d like to know more about any of these topics or would like me to cover other topics in my insights, we welcome the conversation and suggestions.

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