Although the stock market continues to ride the crest of recent highs, many investors are still reeling from the dramatic events from earlier in the year. If they were fortunate (and disciplined) enough to ride out the storm, they might still be a little shell-shocked, but their portfolios are no worse for the wear. Yet, many may be feeling a more acute sense of vulnerability, wondering whether they could tolerate another market decline and whether they should consider a less volatile investment strategy. However, considering that they didn’t actually lose any money, by conflating their natural aversion to losses with the reality of losses, they could be introducing more risk than they can tolerate.
Acting on Loss Aversion is the Biggest Threat to Your Portfolio
Investors often allow their “loss aversion” instincts to take over during extreme market volatility, convincing them that they will lose more money if they don’t sell right now. In reality, they can’t actually lose any money unless they do sell. But, the prospect of losing money and crippling their financial future is too much to bear, leading to one of the most costly behavioral mistakes investors can make. At that point, what would be a temporary decline in portfolio value becomes a permanent loss of capital, from which it is difficult to recover.
For Accumulators, Biggest Risk is Being Out of the Market
For investors in the accumulation stage, a permanent loss of capital can have a devastating effect on their portfolio growth. Selling a security for a $10,000 loss and reallocating it to cash means $10,000 less earning and compounding returns over time, which can translate to tens or even hundreds of thousands in a portfolio deficit by the time they reach retirement. However, a paper loss of $10,000, while annoying and maybe even concerning for the moment, is typically erased when the market rebounds – as has been the case for the last 100 years.
For accumulators with a sound, long-term investment strategy, the critical lesson to heed is that short-term market fluctuations, while seemingly consequential at the moment, will appear as nothing more than a tiny blip on their long-term investment timeline. The key for accumulators is to avoid situations that could lead to a permanent loss of capital, such as investing in speculative stocks.
For Pre-Retirees, Biggest Risk is Not Having a Plan
Investors’ sensitivity to loss aversion tends to grow more acute as they move through life’s stages. For example, for investors on the retirement glide path – 10 years or less out – a paper loss can seem more consequential. At this stage, any permanent loss of capital would definitely affect their retirement outcome. But even a paper loss could impact the outcome without the right plan in place.
Pre-retirees need to look at their approach to retirement much like pilots beginning their descent. Pilots typically make dozens of adjustments on their approach to account for all the variables they encounter. But they’ve planned for those variables, so the adjustments are generally minor. And, if they are made on time, they will keep the plane on track. It’s no different for pre-retirees who may face many variables on their approach, including changes in their health or job, as well as a market downturn. With some minor adjustments to their assumptions and maybe some small tweaks to their portfolio, they can avoid turning a temporary paper loss into a permanent capital loss.
For Retirees, Biggest Risk is Investing too Conservatively
Retirees are most impacted by a permanent loss of capital. But, they also face risks that can be potentially more harmful than market risk. The risk emphasis for retirees should shift from market risk to longevity risk and the risk of investing too conservatively. For retirees living off of income generated from their portfolios, that income is generally not impacted by temporary market declines.
However, if they sell securities out of fear of loss, their income trajectory can be threatened. The same can be true if they decide investing in equities is too risky. It may feel better for the moment to move to more conservative investments, but, 15 or 20 years into retirement, they may face income shortfalls that can impact their lifestyle. Essentially, switching to a more conservative allocation to “protect” capital can result in a permanent loss of capital when they need to spend it down increases.
In investing, regardless of which life stage you are in, the real risk is not your portfolio’s temporary losses. The real risk is how you perceive and react to them. Paper losses are not real, but risks are. For accumulators, the real risk is selling securities in a temporary market decline. For pre-retirees, the risk is not having a plan in place to account for the inevitable variables. For retirees, their overriding risk is investing too conservatively relative to their potential longevity. In all cases, taking a permanent capital loss is a self-inflicted risk to be avoided at all costs. The best risk-avoidance strategy for that is to have a well-conceived, long-term investment plan that anticipates all your potential risks.
