If you had a piece of land and wanted to build a
house on it, you wouldn’t just dig a hole in the dirt, pour some concrete into
it and start building room by room, hoping to one day end up with your dream
home, would you? Most likely you would do some research, consult with friends
and family and find a professional with whom you could sit down to define your
vision and draw up a set of plans to guide you. With the plans in place, you
would then seek out an experienced and well-regarded builder (perhaps the same
person who drew up the plans, perhaps not) to execute them. Yet so often, when
it comes to planning their financial future, including eventual retirement,
people do exactly the former by diverting their hard-earned money to a series
of so-called investments in a haphazard way with no professional help or
pre-defined plan to guide them.
The house building analogy is one that we use quite
often in our practice to help drive home the importance of planning, but there are
many more that we have heard through the years that are equally effective in
painting the picture for clients. A favorite of a former colleague was more of
a travelling comparison that essentially boiled down to not starting a long
journey without mapping out the route first. The list of potential metaphors is
long and which one resonates with each person is not important. What is
important is why advisors who are committed to financial planning feel so
strongly about the effects of sound planning on the client’s ultimate outcome,
that they deem it necessary to express this relationship in any way they can in
order to highlight the point.
To those of us who believe that having a
well-thought-out plan in place is not only helpful, but essential in
determining financial outcomes for clients, the plan is not simply a collection
of statistics, but a barometer that defines, in advance, what steps will be
taken under different market conditions. A guide for decision making not based
on how we ‘think’ or ‘feel’ during the stresses or euphoria of up and down
markets, but on what effects these steps
historically have had or likely will have on the client’s individual
circumstances.
We regularly cite the statistics of lagging average
investor returns versus those of the overall market, and have addressed some of
the potential causes in previous blog posts (see “It’s Different This Time”,
July 27, 2012). And, as firm believers in many of the main principles of
behavioral finance, we do not see these statistics as particularly surprising
or remarkable. On the contrary, we find the forces of herd mentality, loss
aversion and the like to be expected responses to volatile market conditions. Such
forces need to be addressed, accounted for and counteracted by planning for
them in advance so that important financial decision are not being made during
times of high stress and market uncertainty. Volatility is a natural function
of financial markets (the sensationalist nature of financial news reporting
during highly volatile conditions notwithstanding), and an investor armed with
the confidence of a pre-determined action plan is much more likely to avoid the
costly mistakes that lead to severe underperformance over time than an investor
without one.
There have been roughly 15 recessions in the past
100 years in the U.S., meaning one every 6-7 years or so. Clearly not an
unusual event, and as anyone who studies economics or markets knows, a
necessary yang to the yin of expansion. And because of the irrational
exuberance (as Alan Greenspan so eloquently put it) that so often occurs,
particularly in the late stages of economic expansions, the resulting
recessions can often be equally powerful. The pendulum swings too far in either
direction as it were.
And, while these swings are perfectly natural, each
has a distinctly different feel while it is happening- a feel that, to the
untrained actor, seems entirely new and unnatural. What we see then is the
investor who has built his foundation on little more than some internet
research and the advice of well meaning friends and family, suddenly second
guessing his methods and likely the overall health of the system as a whole.
The steps that follow range from discontinuing contributions to outright
paralysis to conservative repositioning and often culminate in the dreaded
“I’ll just get all the way out until the market turns around” reaction. This last response generally results in
locking in losses at the worst possible time, likely missing the customary
bounce off the bottom and effectively torpedoing the long-term return potential
of his portfolio.
This is not to say that to the investor who has
properly planned for and been coached to expect the volatility that comes with
the inevitable recessionary downturn, it doesn’t also feel new and unnatural.
However, the confidence that has been created through the execution of a
carefully produced financial plan, acts as a bastion against the natural
feelings of fear and loss aversion that set in during such times. What’s more, when an investor is not clouded
by feelings of fear and doubt, she can see the recessionary environment clearly
for what it is, a small moment of opportunity.
By continuing to contribute to investments and rebalance current
positions during market downturns and intervals of great volatility, the
planning client typically takes advantage of a buying opportunity, purchasing
high-quality assets at depressed prices. This effectively lowers her overall
investing costs over time, resulting in potentially higher returns in the long
run.
In our practice, we believe in the the virtues of
comprehensive planning far beyond the effects on just the investment piece of
the financial puzzle, and will continue to preach the gospel of planning to all
of our clients going forward. For everyone else, you might want to make sure
your foundation is solid before starting on that third-story addition.
The
opinions voiced in this material are for general information only and are not intended
to provide specific advice or recommendations for any individual. To determine
which investment(s) may be appropriate for you, consult your financial advisor
prior to investing.
