2018 has been a choppy, volatile and potentially a negative year in most of the major stock markets of the world, although it’s the first time that’s happened in eight or nine years.
In response, it seemed like a good opportunity to address the mistakes that investors make during a market downturn. I’ve observed these mistakes in my professional role as an advisor, but also as a human and an investor myself, so I hope these points will be useful for you.
Understanding the Market
Before we go any further, it’s important for you to understand that the market doesn’t make mistakes. It does what it’s always done, which is move in cycles. Once the decline is over, it will continue it’s soaring advance.
The market itself is unemotional, but people aren’t. When I say ‘the market’ I’m referring to the global stock market or global equity market, which I often refer to as the great companies of this world.
The two biggest wealth destroyers are you, the reader or investor, and inflation. This is because you will make investor errors, and inflation, which is the constant rising of prices which erodes your purchasing power. Money is only ‘purchasing power’ in terms of what it can buy you in the future.
As the market moves in its cycles, the investors themselves are also moving in cycles. In its rawest form, that investor cycle moves from fear to greed, to fear, to greed. During a market decline, fear is what the investor is feeling. They may not come out and say they’re feeling fearful, but that’s what it is.
It’s fair to say that financial advisers actually earn their money during a decline. It’s the point where advisers step forward, hold out their hand and act as caring listeners to their clients, guiding them and keeping them on course. Advisers remove anxiety and help their clients understand that everything that’s going on is normal and expected, and it too will pass.
Clients find it very hard to go through and experience a market decline, particularly a deep one. It can also be enhanced if the market decline starts soon after the start of a new client/adviser relationship.
Remember: The market decline is a test for the amateur. The amateur wants to react, thinking it will help the situation. The expert, on the other hand, knows that doing nothing will get them through it.
The Adviser Involvement
As an adviser I have ‘skin in the game’, I have client meetings where we sit down and update a client’s financial plan, we talk about the portfolio, and I’m invested in the same things as my clients.
I’m invested in 100% global equities, so when my clients feel fearful in relation to their portfolio, its return and its value, I feel the same. I’m invested in my most volatile portfolio, so I will feel the full force of market volatility. Therefore, I’m authentic and have skin in the game. Advisers are there to answer all questions and queries to ensure that our clients are comfortable moving forward.
The Typical Mistakes
These are the most common mistakes I see investors make:
1. Not knowing the numbers going in: It’s important to understand that the market declines 25% of the time and increases in value around 75% of the time. These are good stats!
2. Forgetting the 75/25% rule: You need to know these numbers going in, and don’t forget them.
3. Not sticking to the plan: Your financial plan is the important thing to focus on, not the temporary declines, volatility or unpredictability of investment markets.
4. Employing an adviser just before a downturn: You may be more aware of the volatility in the markets if you’ve just changed adviser, but it’s not a reflection on their skill or quality if the portfolio has declined soon after they’ve taken over its management.
The market will dictate the returns and not the adviser. The market has far more influence on the portfolio than the adviser themselves, who are giving you access to the markets.
5. Money illusion: For example, a client invests £100,000 with adviser A, and during the time they’re investing with them the markets have been favourable, making the portfolio worth £150,000.
The client then decides to work with adviser B, who takes over the management of the £150,000 portfolio. The client then experiences ‘money illusion’ – anchoring the value of what they think they’ve invested as £150,000 rather than £100,000.
If a market decline happens very soon into working with adviser B (which is very likely), the portfolio then goes down to £135,000. The client wrongly thinks they have invested £150,000, which has now gone down to £135,000.
This is technically correct, but an unwise statement to make. The client invested £100,000 in the markets, so the portfolio now is still higher than when they originally invested however as they switched adviser/funds/portfolio they have ‘anchored’ the amount they have originally invested (£100,000) to the amount when they switched the portfolio (£150,000). There may have been a small tweak to the fund, but it’s still broadly invested in the same asset classes.
6.Making statements instead of asking questions: This is common if the client is unfamiliar with a particular area they’re investing in, and they don’t ask enough questions.
I don’t make statements to my plumber or my doctor. I ask questions, because I don’t know the subject area well enough. Yet, in investing and finance, people make statements, such as: “I should never have invested.” Instead, they should ask the question, “Should I be worried about what’s happening now?”
Likewise, they may say, “We need to change the fund.” A sensible question would be, “Does it make sense, switching funds?” Or, “We should have had more money invested in country X”, rather than, “Do we move money between the countries now?”
7. Acting on the fear: This is the emotion that clients are feeling during a temporary decline. Feeling the fear is called being human, acting on the fear is called being irrational. It’s a big mistake, and one that’s lurking around every corner for the end client.
8. Switching the portfolio: Only switch an investment portfolio if the financial plan has changed, not the other way around. You don’t switch an investment portfolio due to how the markets are behaving.
We know how the markets are behaving, because the portfolio is set up knowing how the markets would behave. If your financial plan has changed, then your portfolio may be changed.
9. Market timing: Trying to time the markets and moving in and out. This usually happens after a decline. Say the markets declined by 10 or 15% - an inexperienced investor would then say, “Ah! Should we be coming out of the market now?”
When you try and time the markets, you have two decisions to make. The first is when to come out of the market (e.g., when the market has declined by -15%). The second decision, which you have to make if you do decide to come out, is when do you go back in?
Very rarely would somebody come out of the market entirely, wait until it has declined by -25% and then get back in. That financially would be a good move, however extremely unlikely that any average investor could pull it off. You know that if someone is fearful when the market has declined by -15%, if it declines by -25% they’re going to be even more petrified and irrational.
What they’re going to do is wait until the markets have come back up and risen to a higher level than it was when they came out of it, and then they’re going to get back in.
They’ve had two decisions to make, and it’s massively likely they’ll get them both wrong, and then they’re going to do something called ‘selling low and buying high’, which is a proven way to go broke long-term.
Trying to time the markets and move in and out of them is madness and it’s never been proven to work, but it is something that an inexperienced investor may think about doing.
10. Thinking of investments as funds rather than asset classes: I try to explain to my clients that we’re doing ‘asset class investing’, and we use ‘funds’ to access these asset classes. Very high-level asset classes are split between equities and then fixed income or bonds, which is basically lending money to governments and companies. Fixed income assets are generally considered less volatile and also produce lower returns, particularly when you factor in inflation.
Most portfolios are split between equities and bonds, and equities are split between developed markets (those which have been around for hundreds of years) and emerging markets (which have been around for a shorter time and are less developed). Within that, you have small and large companies, value and growth companies. The split between equities and bonds is what will drive all of your returns.
11. Not realising the role of ‘fixed income’: Fixed income is an emotional asset class, so during a temporary decline the more fixed income you have in your portfolio, the less your portfolio will decline by.
However, on the flip side, the more fixed income you have in your portfolio when the market’s rising, the less your portfolio is going to rise. What I frequently see is ‘cautious’ investors in a temporary decline say things like, “I’m not very happy about this decline”.
They don’t say, “It’s great that I’ve got 50% of my assets in fixed income, because this temporary decline would have been twice as bad had I had all of my assets in equities.” They can’t intellectualise the role that fixed income plays during a temporary decline in the great companies of the world.
12. Taking advice from people who don’t have skin in the game: I have skin in the game as I look after my clients’ life savings, tell them what to do with it and caringly nudge them on the best course.
People who don’t have skin in the game include those giving tips in the media, who can say what they want and aren’t accountable. We call it ‘financial pornography’, and includes talking head money channels, the news and money sections.
These are people that give advice out there to investors or people in any way have no skin in the game. I’d always say, if you think they’re right, ask them to do the following for you:
Build you a comprehensive financial plan that maps out all of your goals and transitions that you want to achieve, serve this financial plan with a historically-appropriate global equity/bond portfolio, ideally more equities and ensure YOU stick to it.
If you think they can build you a financial plan, fund it with a portfolio and ensure you stick to it, then by all means, do exactly what they’re telling you to do. They obviously can’t do that, because they’re sensationalists who are just grabbing eyeballs. In your search for ‘outperformance’ you end up doing the exact opposite.
13: Not appreciating that all declines in a globally well-diversified equity portfolio are temporary: And likewise, that the advance, when it continues, is permanent. You need to have a clear understanding of this, and remember the 75/25 rule (see point 2).
14. Thinking you can pick winners in advance: Or thinking you can pick winners at all. Assuming you can identify a winning country, company or fund (in advance) after it’s done well, is like picking race horses after the race – easy in hindsight, proven impossible with foresight.
Inexperienced investors will say, ‘Look how well this has done. Why don’t we invest in it?’ Sometimes, it’s seen as a counter-signal – the worst-performing country last year is frequently one of the best-performing countries this year. But that was the question you asked.
15. Looking too much at your portfolio: When the market’s declining, the more you look at your portfolio, the more you will fill up with financial anxiety. The less you look, the better you do. A lot of anecdotal studies have proven this.
Remember: Money is like a bar of soap, the less you touch it, the more you have.
16. Taking your eye off the financial planning ball: You need to keep working your financial plan and leave the investment portfolio to do its job. You don’t tinker with the investments, you tinker with the investor.
17. Losing sight of why you are investing: Most people, even me, are investing for a dignified and comfortable retirement, and to create multi-generational wealth – helping out the next generations.
You invest today so your grandchildren can dance. A mistake is to lose sight of why you’re investing. Everyone who invests money long-term is hoping that money will provide them with a comfortable retirement, and once that’s been achieved it’s about the next generation.
18. Stopping your automatic monthly savings contributions when the market temporarily declines: I also see people stop increasing their monthly contributions at the same rate during a decline.
For example, let’s say that two years ago a client was investing £500 a month. Then a year ago, they increased it to £600, so this year they’d be expected to pay £700 a month. But, because the market’s declined, they decide to wait and not make the increase. This is financial madness. Similarly, this might happen if someone is paying £500 a month and decide to reduce that to £300 when the market’s a bit choppy.
As an automatic saver, someone who’s paying themselves first and investing every month, when you see red in the investment markets, this is a financial gift from God. It’s when you continue to invest monthly, and ideally increase it to the maximum amount that you can contribute.
You are buying an asset, ‘the stock market’ ‘the great companies of this world’, on a monthly basis, and when it’s on a temporary sale, you decide to not stock up. Think about it. If you were buying TVs, apples or petrol for a living, when there was a temporary decline on it, you’d go all-in on the asset class.
A big mistake I see is people stopping, reducing or not increasing at the same rate their monthly contributions during a temporary declining market. This is financial madness.
19. Thinking that you're rational and that you make rational choices: Clearly not! An average end consumer has not heard of behavioural economics or read the book, ‘Nudge’ or know who Richard Thaler is (the author of Nudge), or Daniel Kahneman. The issue is that people don’t know what they don’t know, but the mistake they make is that they think they’re rational when they’re not.
20. Not realising a professional adviser is there to help: They should not be the focus of underperformance. The underperformance is a market factor and what the stock market does, it’s not the adviser factor.
If you decided to switch because the market declined, the next temporary decline, which is probably just around the corner, you may switch again. You’d be constantly changing advisers, when the issue is you and not them.
You’re switching advisers when you need to switch investor behaviour – i.e. what you’re doing. An issue I often see is people not realising that a professional adviser is there to help and shouldn’t be the focus of any underperformance.
They’re there, have skin in the game and can talk you through this, but again, it’s about separating the investment performance and the asset class performance with what your actual adviser is doing.
21. Clients of advisers become friends: One reason for this is that friends listen to each other. We have to think of a market decline as a financial tornado, rare but frequent. When the tornado comes, we pull our clients closer to us, and have on our horizon the tornado making its way towards us.
As it gets closer and closer, we pull the clients in tighter and tighter. When the tornado is right next to us, we’re pulling in to a tight huddle, and then we’re through and into the eye of the tornado, the financial storm. But we’re all in tight, and if anyone pulls away now, they’ll get swept away and off they go.
The tornado will move past us and then it’s gone. During the time of the financial tornado we move in tight, didn’t move, react or do anything, and then it made its way on its journey. That’s how you have to think of market declines. You need to pull in tight and not react. Let the financial tornado go.