Everyone has learned a little something from this experience in crisis (COVID-19), including us investment professionals. While we all may have the overwhelming urge to speculate, we urge investors and savers alike to step away from that line of thinking when it comes to investing.
This doesn’t mean sit completely still and not take advantage of the many investment opportunities that have presented themselves; It means that we don’t want to make too large of plays in any given direction due to our own speculation.
As investors, we need to shift our thinking away from speculation and instead focus on process. As our team has alluded to before - Crises tend to exacerbate underlying trends that were already happening. That being said, our focus has turned towards trends that were already happening before the crisis that are likely to become accelerated down the road (good or bad).
We should instead ask ourselves questions, then look to see if there is any evidence to support the validity of those questions. An example of this could be:
“Will this crisis cause more-and-more businesses to shift to using cloud-based technology?"
"Will already struggling retail malls (due to e-commerce) make it through this? Will mall retailers need to adapt to other forms of product distribution?
If there is evidence that shows significant support and rationale, then we can adapt meaningfully without relying on pure speculation. The thought process I discussed can help investors avoid a few common pitfalls associated with behavioral finance. These investor behaviors are known as anchoring, the endowment effect, and loss aversion - which have become more apparent during these crazy times.
Anchoring, the endowment effect, and loss aversion
As financial professionals, our team often finds ourselves encouraging clients not to “anchor” – anchoring is a concept in behavioral finance with a plethora of research to back it up. This occurs when investors are influenced by purchase points or arbitrary price levels. They cling on to these numbers as a decision point to buy or sell.
A common example is when an investor buys or inherits a stock at a given price or value, then the stock’s value declines over a period of several years. The investor decides not to sell the stock until it gets back to that arbitrary price they bought or inherited it at – regardless of the circumstances.
The problem here is that the arbitrary price you bought (or inherited) your stock at does not matter to the markets. The stock’s price will move according to many other factors. It may never return to that price, and if it does there is no way to know how long that may take.
Another phenomenon that can take place related to anchoring is called the endowment effect. In behavioral finance, endowment effect describes a circumstance in which an individual places a higher value on an object that they already own than the value they would place on that same object if they did not own it.* The endowment effect can go hand-in-hand with anchoring.
An example of the endowment effect:
An investor buys or inherits stock in ABC company. ABC company’s stock price has fallen significantly due to consistent financial struggles that have now been exacerbated by COVID-19. The investor is anchored to the price they bought it at and doesn’t want to sell until it returns to that price point so they can “get their money back”.
Although they may not realize it, the investor is basically saying that their stock is actually worth far more than it currently is valued. However, let's say the investor did not currently own this stock and instead was looking for a quality investment to buy into; they would likely not be purchasing ABC company given the circumstances, even at its currently reduced value.
We have found that many times it makes sense to accept your losses, rip off the band-aid, and diversify appropriately (which might also benefit you from a tax perspective). Although some investors find this extremely hard to do, even when they know diversifying could increase the probability of investment success in the long run. This brings up the well-known concept of loss aversion which is the tendency for investors to refuse to take a loss – which at the same time causes investors to take on additional risk – simply to avoid the pain of a loss.
Choosing to reinvest and diversify after accepting a loss can also help you avoid greater losses that your investment(s) may experience going forward. In reality, investors actually “win more by losing less”. The more you lose, the more return you need to get back. If you have $1, and it drops to $.50, you lost 50%. You now need to make 100% ($.50) to get your $1 back. This is why waiting in concentrated positions to hit an arbitrary number can be a dangerous proposition.
How investor behaviors relate to the effects of COVID-19
We are seeing these negative behaviors play out first-hand amidst the COVID-19 crisis. Some undiversified investors hit hard by the pandemic are betting that their highly concentrated investment(s) will quickly come climbing back to their recent highs once the market eventually “rebounds”. And not until then will they decide to make decisions to change their investments or process – no matter the circumstances. These investors are at the mercy of their own biases and can be overconfident in their speculation of the unknown. Rather than focusing on a specific number in the near-term, investors should focus on how to successfully reach their goals over the long-term.
While assessing the changed landscape brought by the COVID-19 pandemic, we see evidence that suggests that certain economic sectors may build back to pre-crisis levels far sooner than others. In fact, this has already begun to happen (think e-commerce vs. travel, or the oil and gas industry).
Let us use the process previously mentioned, and the current situation these industries face as an example of how these behaviors are being exhibited:
An investor owns stock in XYZ company, a business that has already been beaten down over a number of years due to lack of innovation and adaptation. The investor has been holding on because they did not want to accept a loss in the stock and figure it “has to bounce back soon”.
The COVID-19 pandemic has now made it increasingly difficult for XYZ company to survive given a significant change in consumer behavior. This was a trend already occurring in XYZ company’s industry, COVID-19 has just accelerated that trend.
Would it still make sense for an investor with a concentrated position in XYZ stock to hold on just for the sake of their investment returning to an arbitrary price? – Current evidence shows that this could be a slow and painful climb for this industry (if it climbs at all) as opposed to other industries.
Could they ask themselves objective questions using a process in an attempt to increase their probability of long-term success, and create a more suitable portfolio going forward?
Implementing a process can better assist investors in creating what we look at as higher quality portfolios, that can help you withstand market volatility. We believe these portfolios should weather various market conditions through proper diversification. In our example, this might be done by diversifying and reinvesting across different asset classes and/or adding stocks in various industries. This can help eliminate speculation on a particular investment or industry with the goal of increasing one’s chances for future growth and downside protection. Following a process can also help eliminate biases and behaviors that can negatively impact long-term performance.
The bottom line
-Studies have shown (and my team has personally seen) that investment results are more dependent on investor behavior than on the performance of the investments themselves. Investors are generally their own worst enemy.
-Understand the true risk present in your investment portfolios. Click here to gain an understanding of your current portfolio.
-We believe anchoring, the endowment effect, and loss aversion can be some of the strongest influencing behaviors in times of extreme market volatility such as those caused by COVID-19.
-We aren't suggesting you sell all of your losing investments. Depending on various circumstances, it may still make sense to hold on to badly beaten investments.
-We propose that investors move away from hopes and speculations to determine their financial futures, and instead utilize a plan and process to increase the likelihood of financial success.
-For insight on some of the strategies we use at GMV & Associates, visit our blog - Plan-It.
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ in Riverside, California
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. The information presented does not constitute a solicitation for the purchase or sale of any security and is not a recommendation of any kind. Please consult your financial advisor before making financial decisions. Diversification is an investment strategy that can help manage risk within your portfolio but it does not guarantee profits or protect against loss in declining markets. Investing involves risk, including the potential loss of principal. Keep in mind that rebalancing may have tax consequences and transaction costs associated with this strategy. Please consult with your tax advisor regarding your personal situation.