As investors, we’re accustomed to hearing about risk: market risk, inflation risk, currency risk, and so on. No form of risk, though, challenges investors quite the way uncertainty can. In my experience, how well we respond to uncertainty can be a key to long-term investing success.
Of course, we never have the luxury of complete clarity when investing—none of us has a crystal ball, after all—but the current environment seems to have more than its fair share of uncertainty.
Plenty of question marks surround the economy as a new administration rolls out its policies, the Federal Reserve shifts its thinking, and global growth, especially in China, continues to worry market watchers. A general feeling of unsettledness is reflected in many of the questions I’ve gotten from investors in recent months, and I’m sure you’ve heard them too.
Confronting the challenge of the unknowable
First, a bit about the difference between risk and uncertainty. Risk can be measured, albeit not with 100% accuracy. An investor armed with the right data can calculate a reasonable probability that, say, a given company will miss earnings expectations.
Uncertainty can’t be quantified that easily. “Black swan” events fall completely outside the realm of the expected. The data needed to make sense of such an event are either not known or unknowable.
In times of uncertainty, it’s easy for investors to make bad decisions. Markets often respond to surprise events with volatility. We had plenty of those in 2016, and I expect similar market-rattling events to occur this year. Some investors may interpret volatility as a sign of trouble and flee to whatever they perceive as a safe haven. Others may see buying opportunities at every turn. Both are likely to fall prey to common investor biases, such as these:
- Focusing on just the information that confirms our decisions.
- Buying into the mistaken belief that past performance indicates future results.
- Sticking to the familiar at the cost of smart diversification.
The problem with these natural inclinations is that they can make us forget about our long-term investment plan. That’s why it’s important to play the role of behavioral coach and keep your clients focused on long-term goals instead of short-term reactions.
Avoid unforced errors
Sound investing was ingrained in me from an early age. My mother and father did a good job of saving for retirement by building a diversified portfolio. They recognized that diversification is the most logical response to a future that is, inevitably, uncertain. But my family, just like your clients, was susceptible to these common biases.
In the 1990s tech boom, my mom, who has always paid close attention to the markets, wanted to invest in some of the high-flying stocks of the moment. She had read about these and heard about them on TV, which confirmed her thinking that they were good buys. On a separate occasion, she also wanted to sell in March 2009, Those were scary times, and she was just trying to protect the nest egg she had so diligently built up over all those years. I’m happy to say she rethought both decisions.
None of us, of course, is immune from mistakes. I can fall into traps as well, so I’ve tried to develop habits that help me counter the biases that affect most of us as investors. These habits don’t require great investment acumen. They’re just the habits you want to pass on to your clients.
For example, I try to remove emotion from the investing equation. At the end of every year, I look at my retirement account and determine if I need to rebalance. Rarely, though, do I spend time trying to figure out why a certain fund over- or underperformed. I don’t want market noise to tempt me.
Another way to cope with uncertainty: Save more. Just as we can’t know for sure where the markets are headed, your clients can’t predict when they might have to contend with a health or career setback. Putting away something extra isn’t easy, but it can give them the flexibility to make the most of bad situations.
The one thing we can be sure of
In investing, there is always going to be uncertainty—and a little pain. It’s difficult to continue dollar-cost averaging into a tumbling market. Likewise, short-term noise can tempt us to not rebalance regularly. Disciplined rebalancing is vital to achieving long-term goals. To paraphrase legendary investor John Neff, the best time to invest can be when your stomach is churning the most.
Because my portfolio is fully diversified, it always contains something that underperforms expectations. There are almost always surprises on the upside too. This is the power of diversification and a secret to investment success.
All investing is subject to risk, including the possible loss of the money you invest.
Diversification does not ensure a profit or protect against a loss.