To put the stock market’s performance of late in perspective, the S&P 500 index has nearly doubled since 2019, up more than 90% in just three years. That’s despite the market suffering one of its steepest declines in history, erasing more than 30% from investors’ portfolios. But that historic event was followed by one of the sharpest and quickest market recoveries in history. From there, the market resumed its climb to record highs.
That stock market outperformance is unprecedented and has, unfortunately, led to a level of complacency among investors not seen very often. Complacency in investing is dangerous on several levels, but its greatest threat is when it causes investors to become detached from reality. While there’s no denying that the current trend of the stock market is up, and in all likelihood, will continue to be up, such an extended period of exuberance can have the effect of warping investors’ expectations.
Why Managing Expectations is Crucial in Investing
The ability to manage expectations in investing is crucial because it creates a buffer between emotions and the realities on the ground. However, when reality no longer matches expectations, it can lead to emotionally driven behavioral mistakes. If you expect that stocks will continue to rise because they’ve risen for the last 18 months, they’re likely to be shattered when the market starts to decline for a couple of weeks, even by a relatively small amount. That can cause some investors to break from their strategy or exhibit other behaviors that are not conducive to their long-term goals.
The red flags have been popping up for me over the last few weeks as the market began to show some weakness. One example was a client who called me very concerned about the market’s activity which she described as a “crash.” It’s one thing to become uneasy when the stock market spends any amount of time on the downside. But it was jarring to me that she would use such an emotionally charged term as a “crash.” She wasn’t deeply panicked, and she listened with reason when we discussed how such a market move could actually create opportunities.
I seemed to have talked her down from the ledge and refocused her on her long-term investment objectives, resetting her expectations in the process. However, my concern is for clients without the benefit of a timely conversation with a financial advisor, who might act on their emotions and cause irreparable harm to their financial future.
Shattered Expectations Lead to Costly Behavioral Mistakes
When their expectations aren’t met, the first instinct for many investors is to sell into a market decline. Their thinking is that a typically normal five or ten percent decline could worsen, so they want to limit the damage. Never mind that the market always rebounds from such drops and goes on to new highs. In the meantime, they’re missing out on those opportunities.
The same holds for investors who stop investing their money if they perceive that the market will continue to decline. That is precisely when they should be investing because they don’t know if the market will rebound the next day or in 30 days or six months. But it will rebound, and there will be more missed opportunities.
The Key to Effectively Managing Expectations in any Market Environment
In trying to help clients manage expectations, we can talk about the stock market’s history and that, for every market decline, there has always been a market rebound. And, for every bear market that lasts, on average for 14 months, a more enduring bull market follows, lasting, on average, three years. That helps to a certain extent, but investors can still be uneasy because they can’t control what happens in the future.
A more effective way of managing investment expectations is to focus on what you can control. You start by accepting that the prices of securities at any given moment are, at best, an imprecise view of the actual value of the underlying investment. They’re an approximation of the value of something you own. Therefore, investors should not place too much importance on the prices of securities at any given time because they naturally fluctuate over time.
With that understanding, the more important thing to know is what you own—the underlying investment or company—and form an independent opinion on its value based on objective points of reference. That way, you can ignore the market’s view of the prices you’re seeing or possibly even profit from the disparity.
For example, say you own shares in a company you believe to be worth $100 a share based on the research and information you have, and the market is pricing them at $70 a share. You can ignore that pricing, knowing what your investment is actually worth, or you could profit by adding more discounted shares to your portfolio. Either way, you’re in control because you know what you have and what it’s worth. That’s your reality, not what the media or market is telling you.
