You probably know that any investment you make comes with risk. While many people think “risk” has a negative connotation, it’s actually not an inherently bad thing.
We need risk in order to have the potential to earn a reward. The greater the risk, the greater the reward we can expect to have — and in this case, “reward” means a financial gain. However, risk also comes with the possibility of a financial loss instead.
The more risk you take on, the higher your upside potential and lower downside risk. If you take on less risk, you will earn a smaller reward… but you also have a more limited chance of loss.
Knowing all of this is one thing. Experiencing it in the way we have recently due to the impact COVID-19 on the financial markets is quite another… especially if this is the first time you’ve personally sat and watched your portfolio take a nosedive.
Once you actually get a front-row seat to how fast and how sharply the stock market can go into a tailspin and wipe out gains to leave you with losses, it’s understandable that you might want to look into reducing the amount of risk you take on through your investments.
But reacting to a loss by reducing the amount of stocks you hold now is a bad idea. Here are three big reasons why.
1. Reducing Risk Now Means You’re Acting with a Recency Bias
As an investor, the last month has been hard. There’s no denying or getting around that. Seeing your stocks drop 30 percent or more in some cases is tough and no one likes to lose money.
And yet, we still have to be careful to avoid irrational decision-making as we seek the best path forward.
We as humans tend to get tripped up over something known as recency bias. That’s when we rely on our most recent past experiences to inform us about what seems likely to happen in the near future.
This actually works pretty well for us when we’re determining the likelihood that a restaurant we went to and enjoyed a good meal at last week will provide us with a similar pleasurable experience if we go again this week.
But depending on recent experience or memory to interpret what is likely to happen next gets you into big trouble when it comes to investing… because past performance is no guarantee of future results.
The availability heuristic might play a role here, too. This is what happens when we (often mistakenly) believe that the easier it is for us to remember something, the more important it is. How easy it is to remember something greatly influences our analysis of what to do next.
This might explain why you might feel like the recent market drop is more important than the decade-long bull market that preceded it. It’s also why in times of growth and prosperity, people tend overestimate their risk tolerance, but in times of crisis, they underestimate it.
Ultimately, we need to remember the stock market goes upward over time, over the long run. Keep that in mind, and know that your asset allocation and stock exposure should be calibrated to that big picture (rather than current events).
2. If You Reduce Exposure to Stock, You Take an Unrealized Loss and Lock It In
While it’s understandable that you would feel spooked by the marketing falling significantly, acting after the fact doesn’t do you much good. In reality, you’re only guaranteeing that you lose money.
Those who stay in the market and stick to their plan realize the same risks that you do… but they’re the only ones who get the potential for the reward on the upswing because they stayed to experience it!
History shows that the stock market rewards investors who can bear the volatility of stocks and avoid the harmful behavioral traps through various periods of performance.
Make sure you understand what the real risk is you face when you invest… and it’s not in experiencing the next 20 percent market decline. It’s not being in the market at all when it experiences its next 100 percent increase.
If you look back to the Great Recession that ran from 2007 to 2009, stocks dropped nearly 60 percent from their highs. That sounds scary, but investors who stayed invested and kept their exposure to stocks steady may tell you it wasn’t so bad.
Why? Because after the drop, they got to experience the 300%+ gains that happened throughout the 11-year bull market we experienced through the 2010s.
Whenever you’re tempted to reduce your stock exposure, remember to ask yourself: when will you ratchet it back up? When will you know we’re past the bottom and on the way back up?
The reality is no one knows that with certainty, Nost investors who jump out tend to do so after the worst is over and don’t get back in until after the recovery already started… which leaves you selling low and buying high.
You wouldn’t see a pair of shoes at the store on sale for $50 one day, then come back to see them at $30 the next and think “no way am I buying those at a cheaper price! I’ll wait until they’re more expensive again.”
And yet that is exactly what most people do with stocks. Does that make sense to wait to buy something until it is priced higher? Of course not. Stay the course and carry on with your investment plan.
3. If Your Goals Didn’t Change, Your Investment Plan Shouldn’t Either
Times like these only serve to reiterate the reason why we start your financial planning and investment management process with your goals — not how you feel about the market on a given day.
Odds are you still want to plan to buy a house, or pay for your child’s education, or reach financial independence. Those goals haven’t changed, and it’s those goals that should determine how you need to invest to reach them.
If the goals didn’t change, your investment strategy shouldn’t, either. Your plan accounts for periods like these, because we know downturns will happen. We expect them, we just don’t know the details like “when” or “how much.”
We also know that regardless of what the short-term market movements look like, you still need your money to grow over time. Investing remains an ideal path to growing wealth.
If you reduce your stock exposure from what your investment plan said you needed to set in order to reach your goals, you may not have sufficient funds in 20, 30, or more years to achieve what you want — and that’s the biggest reason why now is not the time to jump out or try to minimize the stocks in your portfolio.
Stay the course and keep your focus on the long term.
