When the market's on the upswing, as it has been over the past several years, do you feel like you should be pouring even more funds into your portfolio? How about when the market has a downswing, as it inevitably does? Is your first reaction to get out and wait for a better time?
If so, you're definitely not the only one. In fact, it seems as though it's human nature to make investment decisions based on emotion. Unfortunately, reacting emotionally to market ups and downs isn't a good idea. Read on to find out why...
and learn a strategy that will help you banish the emotional response and make better investment planning decisions.
Investment Planning: Get the Worst Case Scenario Out of the Way
It's not hard to understand why so man
y investors react to market lows with emotion and end up selling near the bottom. After all, when the market drops, it's easy to panic and react impulsively. However, empirical studies by Vanguard illustrate the measurable differences between staying the course during volatility, and pulling out of the market during a decline, then re-entering the market when it's risen again. In Vanguard's case study, a $10,000 investment made in 1988 yielded more than $128,000 in returns in 2013 when the investor didn't react during turbulent times. In contrast, the same $10,000 initial investment only yielded $82,000 in returns when the investor pulled out of the market when the account balance declined by 25 percent, then re-entered when the market had risen by 15 percent.
The difference is striking, and underlies the need to remain disciplined and not react emotionally to volatility. So how can an investor overcome this apparently "natural" instinct to react and take action? By employing a concept known as a premortem investing strategy. Introduced by psychologist Gary Klein, Ph.D., the premorten strategy is a thought exercise or experiment that allows you to analyze the potential results of a market failure before it happens. It's the opposite of the post-mortem so commonly employed in business settings, used to assess what went wrong with a particular project.
First, imagine that the market has declined significantly, perhaps by 25 to 40 percent. Next, hypothesizing as to which factors led to this decline; was there a natural disaster? A terrorist attack? International stock market crashes? Come up with a few systemic or market risk scenarios that could lead to such a decline across the entire market, not just in certain asset classes.
Now What? Using a "What if..." in Wealth Planning
Now that you've imagined the worst, take the time to imagine what a rational response to each scenario would look like. By thinking about potential scenarios, you'll be less likely to get caught up in the euphoria of a bull market. You'll be more aware of situations that could be coming down the pipeline that may lead to a market decline. As a result, you'll take a more rational approach to investment decisions.
Take time to reassess your financial needs and goals. You may realize that your portfolio is unbalanced and exposed to unnecessary risk. Talk to your financial planning consultants about your unique situation. Ask if your portfolio is properly diversified so that it spreads risk over multiple asset classes.
We don't advise to push the worst-case scenarios to the back of your mind. By remaining aware of what might happen — and being cognizant of the potential results of your responses — you'll be more likely to make rational investment decisions.