"The average long-term experience in investing is never surprising, but the short-term experience is always surprising."
I'm reading on the couch in my home office when I see a kid in a suit walking up the driveway. Bingo the office dog starts going crazy - which actually helps me because it gives me a convenient excuse to not talk to unsolicited visitors.
It turns out he just started working for a high-cost mutual fund sales company that disguises their salespeople as financial advisors (I won't name the company, but their initials are EJ). The kid, quite obviously using a script, starts asking me questions about myself under the guise of trying to get to know me:
Kid: So, what do you do for a living, Eric? (no, I didn't correct him)
Derek: I work with people to help them with their emotions and behaviors around money.
Kid: Cool. I like to think I do that, too.
Derek: I'm not so sure. It seems to me the extent of your emotional work is promoting fear in order to sell mutual funds.
Kid: I don't think so, but let me ask you, Eric; there are a lot of people who are afraid right now because of the markets, including many of your neighbors. Tell me, when was the last time someone did a downside volatility analysis of your portfolio to make sure you won't go broke if this outbreak spreads and shuts down the economy?
Derek: (laughing) Sorry, I can't have this conversation.
Every time the stock markets give us negative returns we can count on the media (and financial salespeople) to make it seem like it's the end of the world. It's the bad news that sells, and it's the bad news that moves products.
Let's put some perspective on what to do when we see scary markets. What I hope to show you is that the day-to-day market movements (and even year-to-year) are like the leaves on a tree; they'll blow around in the wind very easily. If you focus on the movement of the leaves and branches you'll freak out. If you can change your focus to the trunk of the tree, representing your life, you'll see that the wind doesn't have nearly the impact as you originally thought.
Why We Get Afraid When Stocks Fall
We're all a little bit weird when it comes to money. There is nothing like money in nature, so this money stuff is quite new. Our brains are instead wired for survival. When we don't have money, or think we won't have money, our brains kick into survival mode.
Survival mode simply means that our rational brains are kicked offline, and we are making decisions that are very short-term and not likely in our best interest. Our subconscious mind, or animal brain, doesn't know about the future - it only knows about trying to get out of the current situation.
Survival mode comes in three flavors - fight, flight, and freeze.
In nature, fight mode is exactly what it sounds like. If you startle a bear (whose cub is nearby), for example, it's likely to engage in fight mode. It will attack you. It fights. With humans, when we're in fight mode we can get into physical or verbal fights. When it comes to money, this can be getting angry and blaming others about our financial troubles. This helps put our minds at ease by letting us avoid taking responsibility for what happened. We might blame it on a politician, an illness, or anything else. Someone did something that we didn't have control of and now we're mad, and making financial decisions when we're mad isn't productive.
Like fight, flight mode in nature is pretty intuitive. This is when you startle an animal and it immediately runs away. Humans run away, too. In an episode of Seinfeld, the character George senses a fire and instinctively runs away, knocking over old ladies and throwing kids out of his way. This is flight mode. With our money, flight mode means getting as far away from the source of stress as possible. You can see this by people selling out of their stocks after they've fallen and then never go back into the stock market again. Selling at a loss and not participating in subsequent rising markets isn't a recipe for success.
A freeze response happens when we don't know what to do - we freeze up. This happens when an animal plays dead, for example. Humans will avoid having a (perceived) difficult conversation, pout, or put off doing important tasks. Of the three, a freeze response is typically the most dangerous in the long run, as it can sometimes result in trauma, or a financial flashpoint. A freeze response with our money often means financial denial, that is, not paying any attention to our finances, or money at all. It's a defense mechanism that's like putting up a brick wall between us and money so we don't have to deal with it.
What Investment Are
Now that you know how we can involuntarily fall into survival mode, let's talk about how you can avoid going into survival mode.
It starts with understanding what different investments are and how they behave. Once you know that, you can set yourself up to not have to worry about what the markets are doing. A little preparation ahead of time gives you permission to let go of some worry later.
There are three main types of investments and they are quite different from one another. They are stocks, bonds, and cash. Bond and cash investment are loans you make in exchange for interest payments in addition to getting your principal value back. Stock investments, on the other hand, represent you buying a piece of a company and participating in the profits and growth of each company you buy.
Let's talk about each type separately.
Cash investments sounds fancy and high-brow, but you almost certainly have some cash investments. These include bank savings accounts, money market funds, and certificates of deposit (or CDs) cash investment - even though there is some slight nuance with CDs.
With a cash investment, you lend your money to a bank so they can use it to make loans. In exchange for using your money, you get paid interest. You also have the right to get your principal back whenever you want (that's the nuance with CDs, you have to pay a fee if you take your money too soon). Because you have the flexibility of using your money whenever you want, the bank pays you a lower interest rate.
Bond investments are also loans, like cash investments. The difference is that you are giving up your money for a longer period of time. You lend your money to corporations or governments in exchange for interest payments, plus you get your principal money back at the end of a specified period of time. Because you 1) give up the right to use your money for a set period of time and 2) there is a chance the corporation or government entity might not have the money to pay you back, you get paid a higher interest rate than with cash investments.
Stocks are quite different from the other two because you're not lending your money to someone. Instead, you are becoming a part-owner of a company. These companies issue stock that you can buy and those shares trade in what we call a market. It's a market for stocks - or a stock market.
After you become a part-owner of the company, you get to participate in the profits of the company. This is called dividend payments. In addition, because you are an owner you also participate in the future growth of the company.
Unlike cash and bond investments, you can lose principal value in stock investments (I'm ignoring inflation here for simplicity). If you buy a company and the product they sell falls out of favor, or if a better competitor arises, then the value of your company drops.
Because there is a lot more risk with stocks, over long periods of time you expect to make a lot more than you would with bonds or cash.
Risk and Return Trade-Off
Risk and return/reward are not different things. They are two sides of the same coin. That means that you can't get a lot of reward if you don't accept any risk. Said another way, if you can't take any risk, then you can't expect any reward.
At its core, that what investing is about. Managing the trade-offs between risk and reward. Because it's news of stock markets falling that gets the most attention, I want to focus on the risk of stocks and the potential rewards to owning stocks.
Stocks give us a healthy return. Thus, that return comes with risk. The fact that risk appears is not news. It's not surprising. It's actually expected and part of the whole process. In fact, we should be happy when the risk shows up, because this is the reason we get a higher return with stocks.
Done properly, this is not gambling. With a gamble, you take a risk and hope it pays off. With stocks, you can intentionally set up your finances so that you don't care what stocks do. You win no matter what.
What History Tells Us
You might be wondering what it means to not care what stocks do. Over long enough periods of time, stocks do better than bonds, and bonds do better than cash. This has been the case over the course of history. The key term here is long-run.
In the short-run that's not always the case. But the short-run is what we were talking about when we talked about risk. The risk is that stocks can do worse than cash, especially when you need the money. If you need the money at a time when stocks are down, then you are forced to sell at a loss.
What Should You Do?
Taking all of this into account, think about the money you need to withdraw from your investment accounts in the next five years. If you know you need money, then you can't afford to take the risk. Meaning, if your child is going to college in two years, that money shouldn't be in stocks because you've given yourself no ability to let the markets recover.
This is worth repeating. If you need the money then you can't afford to have to sell when the markets are down. It's not worth the risk.
Once you have the peace of mind that comes from knowing you won't need to sell if the markets are down, you give yourself permission to buy more stocks when they go on sale. Falling markets are actually good for you if you can buy more when they are cheap.
The best news is, you can ignore the headlines when they predict the sky is falling.
It's never as bad as it seems. Even if you track this stuff (which I discourage), the media focus on just large U.S. companies. The reality is that you probably have some small companies, foreign companies, and emerging market companies. Plus, it's unlikely that all your money is in stocks. If "stocks" are down 10% and you 60% of your money in stocks, then you are "only" down 6%. Sure, you are still down, but it's not as bad as the news makes it seem. In addition, you can rest assured knowing that you don't need that money for five years anyway.
You only have one life. Live intentionally.