“I don’t like to risk my money.”
I hear this statement a lot when I talk to people about investing. I cringe when I hear this. Don’t get me wrong, I don’t like to risk my money either, but I know what the person means when they say this. They mean they don’t like to invest in anything other than cash or maybe certificates of deposit.
They think they won’t lose out if they keep their money in cash, under the mattress, possibly buried the back yard in glass jars.
This person doesn’t want to put their money into stocks just to see the market tank and their portfolio get cut in half. They think that by keeping their money in cash, they’re safe. But they couldn’t be farther from the truth, especially over the long term.
And here’s why: the dollar has been the number one asset to fall in every 5-year period since 1900. If you wanted to guarantee yourself a loss over a several year period, there would be no safer bet than the U.S. dollar.
The loss simply occurs due to inflation, which deteriorates the purchasing power that each of your dollars has. We’ve all been around long enough to see the anecdotal effects of inflation.
The can of soda that I bought for a quarter growing up is now a dollar. The house that I live in has gone up in value – it has appreciated but the new homebuyer sees this as an inflated price.
Cognitive Bias and Investing
Not only does inflation destroy the value of our dollar sitting in a bank account earning very little, but we also suffer from a human condition which causes us to put more reliance on recent occurrences and less reliance things that happened a long time ago: recency bias. Recency bias is one of seven cognitive biases that may hurt your investment returns.
Recency bias can distort your objectivity and kill your returns.
You think you have a certain amount of money in the bank and you have an anchor as to what the money is valued. This is your recency bias coming into play.
You feel as though money has the same value as it did yesterday. The problem is: it doesn’t. It just keeps declining every year it’s sitting earning a quarter percent.
Inflation is ruining your money in the long term. Recency bias plays a role in the stock market too.
Recency bias plays a huge roll in the stock market’s wild fluctuations.
Ask yourself this question: Would you be more likely to invest your money after the stock market went up by 20% or down by 20%?
Think about the market going up or down by this percentage tomorrow. I bet most of you would not be thrilled with the idea of putting your money in the stock market after it went down by 20%. Yet, that may be arguably the best time to put your money into the market.
The recency bias causes huge swings in the market in both directions. If we look at the Great Recession, for instance, you have the market declining month over month. Net withdrawals from actively managed stock funds during this period went up while the market kept going down. As the market went down at a steeper rate, the withdrawals from funds increased even higher. More money was pulled out of the market after it had already gone down.
The reasons this happens seems to be pretty clear when you look at human behavior. First, we seek to minimize pain. Seeing your money vanish before your very eyes is painful (it’s better not to look).
Then there’s recency bias which causes us to feel as though the recent losses will extend out into the future.
We also seek confirmation from others, a sort of social proof that we’re doing the right thing. I’m more likely to pull my money out of the market if everyone around me is doing the same thing. I don’t want to be the only sucker in the bunch.
But recency bias doesn’t just cause problems for people when the market’s going down. The same is true in a rising market. I’m more likely to believe that my investments will increase by 7% this coming year if they’ve gone up the past couple of years by the same percentage. Then out of nowhere, a 30% drop in the market leaves me wondering, “how could this happen?”
Your Money Is Always At Risk
The market is not easy to figure out. It’s really just made up of market participants (i.e. you and me) buying and selling, hemming and hawing, irrationally exuberant and dispirited. It’s a good reminder that things don’t go as planned. Your money is always at risk in one form or another.
If you keep too much cash for too long, you’ll lose out because of the detrimental effects of inflation. Too much in the market for your risk tolerance, you’ll lose out when the market declines and you’re forced to sell because you’re human.
For those looking for a practical solution to this problem, we’ve come up with an allocation table that will give you guidance on how much of your money should be in equities based on your ability not to sell after the market declines by a certain percent.
For instance, someone who can stomach a 30% decline in the value of their portfolio could be invested in up to 60% stocks. Someone who can fight to urge to sell at a 50% decline in the value of their stocks could be invested in up to 90% stocks.
If you’ve never invested in stocks – whether it be individual stocks, mutual or index funds – you may not know your risk tolerance. Even if you think you may know, when your portfolio is getting crushed, you’re way more likely to sell at a loss.
Having an understanding of your specific risk tolerance, understanding cognitive biases, and understanding the real results of holding cash over the long term are all keys to being a better investor.