As an investor, what is your biggest single fear? For many of us, when it comes to investing, our biggest fear is losing our money. Fear often drives investment decisions. And when it comes to investing, it can be an investor’s worst enemy.
From my experience, there are three ways people lose money in the markets, and all three are largely based on YOUR behavior. That’s good news, because it means that preventing investment losses is largely within your control. Not your advisors, not Wall Street, not the President or Congress. The bad news is, it can be incredibly difficult to avoid these behaviors.
First, it’s important to distinguish between a permanent loss and a temporary decline. A permanent loss means you’ve lost your money. It’s gone. It’s not coming back. A temporary decline, on the other hand, is temporary. You portfolio went down, but if you wait long enough, it will come back.
What are the three ways to experience a permanent loss?
- Failing to Diversify.
- "Putting too many eggs in one basket." You own a single stock or a handful of similar stocks and the companies go bankrupt. It’s not a temporary decline because it’s not coming back. You’ve experienced a permanent loss.
- So how can you avoid this pitfall? By diversifying. But we must make sure to diversify properly. If your doctor told you to eat a balanced breakfast and you ate all starch (bagels, toast, doughnuts, and muffins) he would probably tell you it’s not very balanced. Likewise, sometimes people think that if they hold a lot of stocks or mutual funds, that they have effectively diversified. That may not necessarily be true if they don’t diversify geographically or across industries.
- Trying to Outguess the Markets
- That may be where we want to move to cash until things settle down, or make changes out of stocks because of the volatility, or we feel this volatility is out of the ordinary.
- These are all very normal and very common responses to what we see and hear going on in the markets, usually from the media. But it’s also important to recognize that these are emotional
- So the key to minimizing the risk of permanent loss is not to outguess the market, but instead, stay focused on the long-term plan (10 or 20 years).
- Excess Withdrawal.
- This means taking too much out too quickly. Time horizon is very important, but so is withdrawal rate.
- One way to minimize the risk of experiencing a permanent loss is to look at your overall allocation (mix of stocks and bonds) and determine a reasonable withdrawal rate that, when accounted for inflation, can sustain your portfolio for as long as you need it to.
Understanding the difference between a temporary decline and a permanent loss can make all the difference in your investing experience and can spell the difference between success, and potential catastrophe for your financial future.