If we were playing a game and offer you a choice of a sure win of $50 or, on the toss of a coin, a chance to win $100 or nothing, while the probabilistic outcome is the same, (50% probability of $0 plus the 50% probability of $100) you would likely choose the guaranteed $50 according to scientific studies. After all, it’s a sure thing—you win. But let’s say we change the rules in the second round, and we offer you a sure loss of $50 or, on the toss of a coin, the chance to lose $100 or lose nothing at all, again with the same -$50 probabilistic outcome. What would you pick?
Most people would gamble at losing nothing despite an equal chance of losing twice as much because they have loss aversion and thus tend to view the possibility of recouping a loss as more important than the possibility of a greater gain.
Now ask yourself how you act when you suffer a loss in your investments? You understand that you don’t realize the loss until you sell the position, so how often do you hold on to a losing stock in hopes that the price rebounds? No one likes to admit they are wrong, so investors often hold on to some stocks much longer than they should. However, the best decision is one without reference to history. It is best to own or buy a security given your current investment situation.
On the opposite end, there is herd mentality. The market is down 33% from the high, and everyone is selling now. Even though selling locks in a loss, so many investors cave into fear and sell at the bottom of the market—often only to regret their emotional decision and want to invest the following day when stocks are up 10%. Unfortunately, when you lose 33%, it will take nearly a 50% gain to return to even. By the time the market is up 10%, you’ve already missed a good portion of the gain needed.
Emotions are something every investor must reconcile, as it is your money, and no one cares about your money as much as you do. That is why you’re more likely to take a chance to lose nothing and why you might want to follow the trend and sell out of the market during a recession. More common is the tendency to buy when market prices are high, as was most evident during the Tech Bubble of 1999. Investors rushed to buy stocks after they had appreciated to unjustifiable levels in hopes that the trend would never end.
Let’s say you are following the Ten Year Rule, and you have 10 years of liquidity needs in fixed-income investments, which are less affected by the volatility of the stock market. If you are working with an adviser, he can reassure you that you don’t need to sell your stocks to raise cash. You have money set aside for the next few years regardless of what the market does. Likewise, when the market is up 30%, your adviser will recommend you sell stocks to fulfill your 10-year liquidity needs.
We have and will continue to recommend selling something that is earning 30% a year (as was the case in 2019) for something that is barely earning 2% a year to fulfill a liquidity need that is eight to 10 years away. Furthermore, fulfilling your liquidity needs doesn’t mean taking the full $100,000 you must live on each of the next 10 years and putting $1 million in fixed investments. There is a good bit of planning involved to determine how much you are receiving from Social Security, rental income or other sources of passive income, and dividends and interest. The shortfall is your liquidity need, the amount you must sell in your stock portfolio and re-invest in bonds.
For investors to be successful, they must first overcome their emotional reactions; otherwise, they will end up selling low and buying high—the exact opposite of what they set out to do. Working with a financial adviser and developing a comprehensive financial plan is a helpful step toward successful investing. It won’t stop you from calling your adviser when the market is down 33% and panic sets in, but it does allow you to have someone on your side to talk you out of your emotional decisions and save you from yourself.
If you have questions regarding your liquidity needs, the experts at Henssler Financial will be glad to help: