When we see the same behavior over and over, we begin to consider it a trend. The latest trend is people wanting to make their portfolios more aggressive by having more stocks and fewer bonds and alternative investments.
When we remind them that we created a diversified portfolio with a mix of stocks, bonds, and alternative investments to protect them in a down market and reduce their volatility, they respond, "I know, but that doesn't bother me. I can handle the volatility."
Thinking back to 2008, I don't recall a lot of investors handling volatility very well. Their anxiety was understandable. Starting in September 2008, the market seemed to be in freefall until March 9, 2009, when the Dow bottomed out at 6,547.05, a gut-wrenching 54 percent below its prior all-time high of 14,164.53 set on Oct. 9, 2007.
We understood people's anxiety over the market's drop then and we understand their reaction to today's market rise, too. Investors have enjoyed a nearly uninterrupted recovery over the last six years. In 2013, the S&P 500 posted a 32.39% percent gain, and through May 31, 2014, the index is up 4.97 percent YTD. Investors are eager to jump on the bull market bandwagon.
Evolutionarily speaking, humans got where we are by being able to identify and adapt to trends. Once spotted, we project trends forward in time and plan accordingly. This ability allowed us to understand the seasons and develop agriculture. However, the same mechanism also can lead to costly investment mistakes. We believe that whatever trend we are in now is going to continue, despite our knowledge to the contrary, and our short-term memories ignore the evidence of prior market reversals.
But we need not relinquish control to our human nature. Before making major portfolio changes, we recommend investors consider these two factors:
1. Our human biology affects how we react to our environment.
We can control our reactions to a certain extent, but our brain's biology affects our decision-making. The reptilian part of our brain controls essential functions and concerns itself with survival. It does not have the capacity to think or learn; rather, it functions on instinct. The neocortex is the part of our brain that allows us to learn, plan, delay gratification, and perform complex mental activity and abstract reasoning.
Stress and anxiety impair our reasoning abilities by overwhelming our neocortex and shutting down communication between the two parts of our brain. When we are fearful and anxious, the reptilian part of our brain takes control. That's the biological fact behind the advice to avoid making major decisions while stressed.
That advice applies to investment decisions, too. Too often, investors make decisions from a place of fear or anxiety -- fear of missing out on a good market, fear of not making as much as the next guy, or fear of losing everything in a market freefall.
While we may convince ourselves that we really could handle the volatility, our biology suggests that is simply wishful thinking. If the markets began to tank, we'd likely see a repeat of 2008 when, according to Morningstar, investors pulled a then record $97 billion out of U.S. stock mutual funds.
2. The potential volatility may not be worth the additional risk.
Imagine you're a professional golfer. You're approaching the 15th hole with an eight-stroke lead. Three golfers ahead of you each used a big club, shot over a water hazard, and got eagles. You are tempted to try the same thing, knowing that if you eagled you could win by 12, but that if your shot falls short, you could lose. Is it worth the gamble?
For those lucky enough to have all the money they need, why take additional risk? Assume you invest more of your portfolio in stocks and your decision pays off. How would you use the extra money? Would it affect your life? Conversely, if you suffered a big loss, how would that affect your life? Is the potential upside worth the risk?
No matter how rich we are, we all have limited resources. In my experience, the more volatile their portfolio, the more time people spend fretting over it. When your scarcest resource is time, does it make sense to spend time trying to add more money when you already have more than you'll ever use? Does it make sense to increase your anxiety for any marginal gain you might achieve?
Before making changes to your portfolio, consider whether it makes more sense to build a portfolio designed to get you the rate of return you need to live the life you want, while minimizing your risks and your volatility. That's a trend I'd like to see catch on.
David Geller is the author of Wealth and Happiness: Using Your Wealth to Create a Better Life. He is the CEO of Atlanta-based GV Financial Advisors and is available for professional speaking engagements.