Were you one of the many individuals who sold stock when the market began to sink in 2008? How much had the market fallen before you sold?
These are two good questions to ask yourself, as the best way to predict your willingness to take future risks is to analyze how you reacted in the last go-around.
If you did sell when the market was down, perhaps now is the time to do something different with your portfolio. For example, Craig L. Israelsen suggests diversifying across seven asset classes dispersed into 12 different mutual funds, in what he calls the 7Twelve portfolio.
This is very similar to the Yale endowment that looks to gain a higher investment return by allocating share between several investment strategies and classes.
Some investors who are diversified across multiple assets groan when the S&P 500 is on a tear, as they believe they could be earning more if they were in an index fund that tracked the S&P 500.
The S&P 500 is an index of 500 of the largest companies in the United States. The weighting of each stock is based on its market cap. Apple has the largest market cap assuming the greatest position within the index, with a weighting of 4.03%, while the smallest holding, Diamond Offshore Drilling represents just 0.01%. Consequently, if the top 10 companies are doing well in the S&P 500 index, the overall index usually performs well. However, the index excludes small companies in either the mid-cap 400 index or the small-cap 600 index. These are companies that are even smaller than Diamond Offshore drilling.
Additionally, the S&P 500 leaves out other investments, such as real estate, commodities, infrastructure, international stocks and bonds. There are times that having these additional investments help in doing two things: smoothing out returns to avoid significant losses, and producing stronger returns by not losing as much as the S&P 500. However, when the S&P 500 is the strongest, investors grumble about not having all their investments in one place, often forgetting they can lose all the gains they have experienced recently.
However, these investors are the same individuals who sell quickly when the stock market declines.
Celebrate the Little Things
There are two additional strategies that behavioral finance has taught us. One is to rejoice over the small wins. The second is to pay less attention to your investments.
Weber’s law states that we prefer to experience small, continual wins rather than one sizeable gain. Rather than looking for a single grand lottery payday, we should be searching for the things that benefit us day in and day out.
Divert Your Attention
Second, we all know of people who look at their investment statements weekly. If you find yourself concerned about whether your account has gone up or down on a weekly basis, you should think about tucking those reports away and create a schedule to view them on a monthly, quarterly, or even annual basis.
It’s also important to avoid selling out when there is a decline in the market. Refraining from this can significantly benefit your returns over time. Recent research conducted by Vanguard indicated that average annual returns can increase by almost 2% per annum if individuals continue to hold their investments as the stock market corrects.
Hang On To Your Investments Longer
The pain associated with loss is often greater than what is felt with gains. As a result, people tend to avoid monetary losses at all costs. When individuals have loss aversions, they tend to sell all of their investments during periods of market disruption. While freeing themselves from low-value investments may be comforting at the time, this decision often results in stocks being sold at the worst possible moment.
The reactions that individuals have to market fluctuations are often reoccurring; therefore, if you sold out in 2008, it is highly likely you will do the same the next time the market takes a turn for the worse. Consequently, you should look to diversify your investments.
No matter what your approach to buying and selling may be, it is always helpful to remove your focus on the day-to-day gyrations of the stock market and look for ways to enjoy the small wins throughout your investment process.