(Photo by Charles Sykes/Invision/AP)
If you knew with 100% certainty that an economic recession was coming, would you alter your long-term asset allocation? If your answer is yes, then proceed to the next question. If you knew that trying to time the market correctly is virtually impossible, would you try to do it anyway? If so, you need to act to prevent yourself from hurting your chances to meet your long-term financial goals.
The biggest threat to our investment portfolio is not market volatility; it is ourselves. We know markets fluctuate up and down. Unfortunately, the behavioral biases ingrained in our DNA often lead us to make poor investment decisions in times of stress. One of the most common errors is the mistaken belief that market timing “works”. I’m not talking about day trading here. I’m referring to the alteration of a predetermined multi-decade plan in response to a short-term fear. The narrative goes something like this: “The market looks rich now, and there is a ton of risk out there. Stocks are going to drop. I’m going to get out now, take my chips off the table and get back in at lower prices.”
The concept is completely valid. The problem is that you have to rely on luck for it to succeed. If you think about it, you will need to have precise timing on two things. First, that the market is very near a top and second, if your prediction that lower prices are in the offing, you’ll be able to buy back in at just the right time and “catch the falling knife,” as they say on Wall Street. Getting one of those precisely right is extremely difficult and making both the market exit and reentry decisions optimally is nearly impossible. There are hundreds of studies from both academia and practitioners that show market timing hurts investor returns. When you take taxes, transaction costs, opportunity costs and bad timing into consideration, the data indicates a buy-and-hold strategy provides better results. So how can we reconcile what we know to be true with the emotional need to “do something” when fear overcomes greed? We can use “Jedi mind tricks.”
A Jedi mind trick is used to get somebody to do something against their will or better judgment. But they can also be used on yourself. There are a few tricks I have used in the past to avoid making the disastrous mistake of selling everything and going to cash. I allow myself to make smaller mistakes. When I can’t resist the temptation to act, I make minor adjustments to my portfolio, not major ones. If making a small gamble on the direction of the market keeps the majority of my portfolio invested, it is a price worth paying. To be clear, the expected value of these suggestions may not lead to a direct economic gain, but they can have a huge psychosocial benefit of “keeping you in the game.” And staying in the game by remaining in the markets through their ups and downs is the only way to achieve your investing goals.
Jedi Mind Trick 1: Increase your allocation to actively managed funds
The shift to passive investment products over the last decade was driven by two main factors: lower cost and better performance. Many investors have come to realize that they are better off in a low-cost, tax-efficient vehicle like an ETF that tracks a predetermined portfolio of stocks rather than giving their money to a manager to pick individual securities. One of the main benefits of active management, though, is to have a skilled professional watch over the portfolio. Their job is to identify and avoid the expensive securities and invest based on the fundamentals of the economy and individual businesses. Just the idea of having someone monitoring the investments, even though they may not be successful, provides a level of psychological security not afforded by investing in a passive, market-cap-weighted index. Having a portion of your portfolio in actively managed funds with a defensive approach to investing may give you enough peace of mind to stay in the market rather than jump out.