Smart401k Blog

As an advisor, I frequently speak to investors that are letting their emotions dictate their investment decisions.  Every day we hear about what the market is doing.  The Dow is up or the Dow is down.  This overload of information has caused many investors to make decisions, based on short-term market movements, that will have a significant long term impact on their account.

While I can certainly understand their sentiment, after-all these accounts are often a majority of their life savings, I try to discourage this behavior because it tends to negatively affect their bottom line.   The three most common mistakes I see or hear about are the following: trying to time the market or failing to follow a long term strategy, investing in funds or asset classes because they have had really good short-term returns and those that hold on to an investment too long.

Let’s look at a couple of examples of how this behavior can affect your hard earned savings.   We’ll start with the importance of following a long-term strategy designed for your situation.

Let’s say that you invested $1,000 in the S&P 500 on the first trading day of 1988.

• If you stayed continuously invested through the end of 2008, your account would have grown to $5,043.
• If you tried to time the market and missed the 10 best trading days, your account would have only grown to $2,594.
• If you missed the 40 best trading days, your account would have actually lost money and ended up at $784.

Looking at the first bullet point, you see that following a dedicated strategy, staying invested and not letting current market conditions dictate your decisions you obtained the best outcome.  (Please note that the above example is based on past results, is for illustrative purposes only and is not indicative of future results.)

Now, let’s look at an example on how chasing short-term returns doesn’t always pay off.

Let’s consider two funds with identical investment objectives, risk and one year returns.  For simplicity purposes we’ll name the funds ABC Fund and XYZ Fund.  Imagine that ABC Fund earns a positive 22% return for the first half of the year and XYZ Fund loses 10% for the first half of the year.  Typical investor behavior will cause an investor to sell XYZ Fund and buy ABC Fund.

Now imagine that ABC Fund loses 10% in the second half of the year and XYZ Fund gains 22% in the second half of the year.  Those investors that sold XYZ Fund missed out on a big gain and exacerbated their loss by jumping into ABC Fund at the wrong time.  This is not uncommon as many investors buy high and sell low.  For those investors who followed a dedicated strategy and didn’t chase short-term returns, they ended up with the same one year rate of return.

Chasing short-term returns doesn’t apply solely to mutual funds.  You will want to avoid chasing short-term returns of specific asset classes. Rarely does an asset class continue as the top performing asset class.  For example, if you click here, you will see a chart that looks like the periodic table of elements.  This chart is called the Callan Chart and contains the most commonly used asset classes.  You will see that several asset classes may be the top performing asset class for one, two or even four years but immediately follow that high performance with one or more poorly performing years.

While you don’t want to get caught up in short-term returns, you should monitor the performance of your investments.  Monitoring your investments will ensure that they are still suitable for your account..  In other words, if a fund continues to underperform its peer group or no longer fits in with your asset allocation strategy, you may need to sell the investment.  This can be particularly hard at times where you paid a much higher price for the investment than its currently trading at.

A fund like the American Century Ultra Fund is a great example.  This fund did really well during the mid and late 1990s which caused a large number of investors to pile into this fund.  Since the market peak of 2000 this fund has regularly underperformed its peer group.  Even though this fund has regularly underperformed its peer group, a number of investors have continued to hold on to this fund.  Those investors want to wait until the fund gets back to what they paid for it.  The problem with this strategy is that while you are waiting for a fund like this one to come back to break even status, you are missing out on gains that you could be experiencing in other funds.

The key is to stay unemotional and only keep investments that are still suitable, fit in with your asset allocation strategy and perform well relative to their peer group.

So, how do you prevent making emotional investing decisions that might lead to a loss?  I recommend developing a dedicated investment strategy that you can follow during good and bad market conditions.   It should be based on your time horizon, your risk tolerance and your investment goals.  Your investment strategy will include a diversified asset allocation strategy and a set of criteria to use when deciding when to buy or sell an investment.  Your strategy should give you confidence that you are on track to meet your goals and will help prevent getting caught up in current market conditions and chasing short-term returns.  It should also include ongoing maintenance.  As both the market and your situation changes you will need to adjust the types of funds in your account and the percentages you invest in each.

If you have a question on your strategy or if you would like help creating one, I encourage you to contact us.  Until then, keep up the boring, unemotional investing and watch for the next installment of Common 401(k) pitfalls.

Buck Wendel, Investment Advisor

This entry was posted on Tuesday, October 20th, 2009 at 1:36 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.