When investments underperform, investors inevitably and rightfully ask the million-dollar question: why?
Often, underperformance is attributed to poor investment selection. But why do some investors find themselves not only underperforming benchmarks, but also underperforming their own investments — in other words, seeing poor returns from holdings that actually did quite well over time? The likely answer is poor investor behavior.
Fees and transaction costs aside, it would seem impossible that one could underperform his or her own investments, but this type of occurrence happens often and not only with stocks, but with mutual funds, index funds and more. This is likely a result of trying to predict the markets or reacting to short-term events in the markets.
In my practice, I’ve witnessed this on multiple occasions with prospective clients. Upon learning of their underperformance, I’m immediately curious to hear more of their story, and the story usually goes like this:
Prospective Client: “Well, things seemed to be going fine for a few years, but then there was a correction, and our [enter your stock/mutual fund/ETF of choice] lost a big chunk of its value. It was at that point that we could not bear to see the value go down any further, so we sold it to protect our portfolio.”
At times like these, it feels like I’ve gone from being a financial advisor to a behavioral counselor. This is a role I find myself playing more and more, especially in jumpy markets. It is simply human nature to abandon something that does not seem to be working well and to buy something only when it seems safe and stable.
However, that strategy will ruin you as an investor. In my example, when my prospective client felt uncomfortable with market performance and sold their holdings to “protect” their portfolio, what they were doing was reacting based on their emotions and ultimately making the worst choice possible at that particular time. Smart investing should not be done with feelings or emotions; it should be done with logic.
Investing fundamentals and actual investor behavior tend to be complete opposites when volatility is present. The key is to consider best- and worst-case scenarios proactively. The best time to consider the worst-case scenario is not after a correction happens, but when things are going well, when things are stable, when panic is not dominating investor behavior.
It’s the same reason airlines hold emergency demonstrations before takeoff, when the plane is safe and on the ground. A time of crisis is not the best time to come up with plans. That conversation needs to happen earlier.
Investors should follow the same principle. When investing, consider a worst-case scenario and ask yourself how much volatility you can handle. Then ask yourself how you’ll react when the market approaches that level.
Then, make a commitment and stick to the plan, not only in good times, but in bad times as well. Develop an investment strategy that fits your time horizon. For many, that time frame may be 20 years or more. Be committed to being a long-term investor and not getting caught up in the day-to-day gyrations of the market. Commit to a diversified asset allocation strategy, and let the rest take care of itself.
You may even consider enlisting the help of a qualified “behavioral counselor” — a financial advisor with a fiduciary responsibility to guide your investments. He or she will help you navigate through the turbulence.
Learn more about Joe on NerdWallet’s Ask an Advisor.