First, before we discuss investments, we need to educate ourselves on what matters and is required in order to be a more successful long term investor. One education topic we revisit periodically with our clients is the difference between risk and volatility. An example of risk, from a planning perspective, is running out of money in retirement. This is a very real risk to those who are retired. Volatility, on the other hand, is not risk. Volatility is the slow, fast, unpredictable price movements in your investments. These price movements can be movements up, or down – or both. In 2019, we saw a lot of volatility pushing company values up. Now, in 2020, we are seeing significant volatility in company values coming down. Over time, this volatility will create averages, as what goes up must also temporarily come down. It’s hard for our “lizard brain” to process this difference, so we tend to confuse risk with volatility, and vice-versa.
Behavioral finance studies how we make decisions, both rational and irrational. This topic is of great interest to us at Flowerstone Financial. We believe that if we better understand how decisions are made, we can be better serve our client’s long-term planning needs. Here’s an example of how our brains are programmed and perhaps how some re-wiring may benefit us. A famous psychological study was able to illustrate how our brain fears the loss of money twice as much as we enjoy watching our money and investments grow. Think about that for a minute. We fear losses twice as much as we enjoy gains. This seems to conflict with how we approach other purchases and our desire to pay less when possible. Paying less feels good, increases our confidence, and likely is the reason why so many retailers have rewards cards with points. We, as humans, like to pay less for as much as possible – with the exception being how we view our investments. It’s been said that human nature is a flawed investor and I agree. I can think of many purchases, large and small, that I’d prefer to make when prices are less, with the exception of decisions with our money and investments.
Now in light of all the recent volatility we’ve seen in the market, how many of us are ready to buy more and invest our cash in significantly lower investment prices? It takes a strong stomach to detach your emotions from the math and declining account values and consistent social media blasts to continue to stay true to your plan. We also believe it takes courage and trust, in a professional with a plan, to help you stay the course, regardless of what’s going on at the moment. We believe that “this too shall pass” and your plan will be your guide.
The good news, as we’ve shared previously, is that automation is your friend in times of significant volatility. Your 401k and Thrift savings plan contributions continue, regardless of where current prices stand. The same may be true in your ongoing contributions to your 529 for college planning and in after tax investment accounts.
Understanding the relationship between risk and volatility is important before selecting your investments. We’ll talk more about investment selection next time…