If someone asked you, “Why is wealth important to you?” what would be your answer? In a survey of high-net-worth families, financial security was the most popular answer, followed by help children become successful, educate children and help the less fortunate.1
Financial security is more than money in our portfolios; it is the confidence that we can continue to live in dignity and support ourselves financially rather than rely on our children.
A diversified portfolio that follows our Investment Policy Statement is most likely to get us to our long-term goals — like financial security and helping our children — yet we worry daily as we watch markets go up and down.
The booms and busts of markets unnerve all of us, even those not investing in the markets. Anita Radcliff and Karl Taylor of the University of Sheffield in Britain found that higher stock prices are associated with better mental health, whereas greater volatility of stock prices is associated with worse mental health. This was true even for people holding no stocks. Their research found that stock prices “matter to mental health because they perform the role of economic barometer.”2
Yet we must be resilient in the face of daily stock market volatility, even decades-long volatility, because our emotions can make us do things that lead us away from our financial goals rather than closer to them. Here is an example of how our emotions can get in the way of making good investment decisions.
Most investors believe that high returns come with low risk and low returns come with high risk, when in reality the opposite is true. Back in January 2000, at the height of the internet bubble, expectations of risk were very low and expectations of returns were very high. This was due to our tendency to extrapolate into the future the very high returns of 1999 and the exaggerated exuberance accompanying the internet bubble.
In contrast, expectations of returns were very low in February 2009, the darkest time of the financial crisis, and expectations of risk were very high. This combination was due to our tendency to extrapolate into the future the very low returns of 2008 and early 2009 and the exaggerated fear accompanying the financial crisis.
Investors who acted on their exuberance in January 2000 — piling into stocks — ended up as losers. So did investors who acted on their fear in February 2009, abandoning stocks and missing out on large gains.
We are wise to remember that we are not immune to misleading emotions, but we can be smart enough to resist them. Once we recognize these emotions, we should pause, take a deep breath and consult with our advisors, making sure to include a review of our Investment Policy Statement.
We can’t control the markets, but we can control our emotional reactions to them.
All investments involve risk principal loss is possible. Diversification neither assures a profit nor guarantees against loss in a declining market.
1The SEI Family Wealth and Succession Survey, “The Generation Gap,” June 2011
2Ratcliffe, Anita and Taylor, Karl B. (November 2012), “Who Cares About Stock Market Booms and Busts? Evidence from Data on Mental Health,” IZA Discussion Paper No. 6956.