When Stocks Go Wild, Here’s How Investors Can Minimize Damage

PHOTO: Traders work on the floor of the New York Stock Exchange during the morning of Aug. 27, 2015 in New York City. Andrew Burton/Getty Images
Traders work on the floor of the New York Stock Exchange during the morning of Aug. 27, 2015 in New York City.

Do you tend to react emotionally to headlines, economic news and market gyrations, buying or selling impulsively and deviating widely from your investment plan?

If so, you’ve got lots of company among individual investors, according to DALBAR, an investment research firm that does an annual study of investor behavior. The study routinely finds, and once again found this year, that individual investor behavior is typically what finance nerds call “sub-optimal.”

Those investors’ errors result in portfolios that vastly underperform major indexes. They’ve been historically prone to make serious errors by reacting impulsively to major market events, such as the stock market crash in 2008, and most recently the major declines touched off by trouble in China.

Misguided individuals tend to sell in reaction to falling values, only to get back in after prices have started to rise. Thus, they sell low and buy high. Not only is that the opposite of the goal of investing, it makes no sense from a process standpoint. If you deviate enough from your investment plan, you don’t really have a plan anymore; you’re just making things up as you go along.

Recent stock market events presented circumstances ripe for such missteps. The Dow Jones Industrial average started August at about 17,598. Amid the turmoil that developed late in the month, the Dow dipped about 6 percent to 16,528 at month’s end. August turned out to be the worst month for the Dow since May, 2010.

Meanwhile, the S&P 500 had its worst month since September 2011, and the NASDAQ, since May, 2012. All the while, measures of market volatility – the degree of fluctuation in values (informally called the fear index) – just about leapt off the charts, registering the most abrupt changes since the 2008 financial crisis.

Doubtless, the record will eventually show that, consistent with historical patterns, many investors deviated from their plans last month, reacting to the plunge by selling.

Naturally, there’s a low likelihood of gain for the average investor caught up in this syndrome. These people are taking their eyes off the prize that can be obtained from disciplined long-term investing. If they would just realize that the short-term warp and woof of the market doesn’t really matter much in the long term, they wouldn’t shoot themselves in the foot by over-reacting to price drops.

Such self-defeating moves stem from misconceptions and misguided behavior examined by the DALBAR study. Other examples cited in the study include:

  • Expecting to get high returns while taking low risk. By definition, the potential for high returns is usually linked to high risk.
  • Harboring hubris that can lead to placing conflicting bets based on a single notion that, more often than not, turns out to be dead wrong. For example, for the past five years, the hyper-inflation crowd has bet against both bonds and equities, markets that tend to move in opposite directions.
  • Following the crowd into poor decisions. The herd is usually wrong, creating value opportunities for the few. They follow each other off cliffs.
  • Regarding errors of commission (e.g., buying the wrong stocks) as necessarily being worse than errors of omission (e.g., failing to ensure that their portfolios are adequately diversified.)

So take a hard look at your investing habits. Are you guilty of any of these behaviors? If so, consider these points:

  • Instead of overreacting to news events and ignoring important considerations, keep calm and stay invested. In the long run, most of these events don’t affect growth appreciably. On average – and the long-term averages are what portfolio management is all about – you’ll do much better by hanging in there, provided that you have a well-diversified portfolio. Even if the markets don’t recoup their August losses for a year or more (which would mean a bear market), this shouldn’t bother people who are planning to be fully invested for another 10 years or more before retiring.
  • While it’s good to have more flexibility than policy-constrained professionals so you can take advantage of opportunities, don’t tear your asset allocation asunder. What you see as an opportunity may be a mirage. In the extreme, deviations from allocations can be driven by a fixation on one stock or sector.

    It may be OK to scratch an itch occasionally, but if you lose a short-term bet, don’t keep doubling down just because you can’t admit you were wrong. If you must stray from your asset allocation, invest minimally so as not to abandon the risk protection it affords.

  • Remember that egos can be expensive. Successful investors have sound allocations and stray only at the margins. They always have an allocation to dividend-paying stocks or perhaps growth stocks. They may periodically pare this back by a few percentage points or add a bit to the allocation. But they almost never make big wholesale bets that blow out their plan.

    If they move a few extra percent of their total investments into dividend payers at the wrong time, such poor decisions don’t tend to hurt much. But if you get fixated on the notion that your hunch that a hot stock will stay hot is right and liquidate too many current holdings to dive into it, you need a reality check.

  • Don’t swim after shiny objects with the justification they’re performing well. Just because a strategy you don’t employ looks good now, that’s no reason to sell assets from a key part of your plan. Remember that you have – or should have – assets for a reason: that their prices are likely to move in different directions than other assets or asset classes you own. Even though a new fund or sector is moving briskly, that doesn’t mean it’s right for your portfolio. And things that are doing great now usually revert to their long-term past average, which is probably less than stellar.
  • Have a good look at your investment plan to make sure it’s sound and that your assets are well-allocated. Perhaps it was a sound plan five years ago but has gotten a bit off track because you haven’t rebalanced to restore it to its original proportions of different assets and asset classes. Make sure your plan is solid and up to date. Then follow it, regardless of the howling market winds outside.

So when the market tanks, don’t think in terms of having lost money. Paper losses are only real if you sell. Instead, remember that you built a portfolio to withstand the risk of one or more parts of it sinking. Sit back and weather the storm. And if the market is ascending, don’t let greed take over. Take comfort in the gains you’re getting from your current, well-allocated portfolio, knowing that it’s also protecting you from risk.

Any opinions expressed in this column are solely those of the author.

Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.