Denial sometimes is a very worthwhile virtue for retiree investors.
That seems like an odd thing to say, since retirees’ livelihoods are crucially dependent on the financial markets. How can burying our heads in the sand be a good idea?
But the stock market’s recent correction—or bear market, depending on which benchmark you focus on—is likely to cause you to react in self-destructive ways. Unless you can change your psyche, which is unlikely, it’s not a bad idea to just not look. Or, if you do look, to do so with your hands tied behind your back.
Consider how the stock market performed in 2018: The S&P 500 SPX, -0.39% fell by 4.6% (after adding dividends back in), after nine straight years of gains—the last two of which were in the double digits. In fact, the stock market in 2018 experienced its first loss since 2008, in the middle of the Great Recession.
The very human reaction to this turn of events is to consider pulling money out of the stock market.
But now consider what your reaction would be if, instead of focusing on calendar year returns each January, you focused on the S&P 500’s trailing 10-year annualized returns. Not only is there a lot less year-to-year variation in this return, right now it’s at the highest since before the Financial Crisis. By focusing on 10-year trailing return, your likely reaction would be just the opposite of what it would be when focusing on the annual results.
Even better, you could focus on trailing 20-year annualized returns, where you find even more consistency. Over the last decade, trailing 20-year annualized returns have varied within a narrow band from a low of 7.2% to a high of 9.9%. Blips in individual calendar year returns hardly even register.
These three return series are plotted in the accompanying graph. Years 1 through 10 on the horizontal axis are the calendar years 2009 through 2018. “Investment A” refers to annual returns for each of those calendar years, “Investment B” represents trailing 10-year annualized returns as of Dec. 31 of each of those years, and “Investment C” represents trailing 20-year annualized returns. The chart readily illustrates that your equity allocation would most likely be much less when focusing on Investment A than on Investment C.
I purposely constructed the chart without labeling what Investments A, B and C represent, since I wanted you to imagine your likely reaction without knowing that the three investments are the same but just looked at from three different angles.
There’s a theoretical reason for why focusing on shorter-term performance leads to a lower equity allocation: Something that behavioral economists have dubbed “myopic loss aversion.” It represents the combination of two personality traits: We hate losses more than we love gains, and we focus more on the short term than the longer term. And since short-term returns are likely to be more volatile, those who focus on performance over shorter periods will have higher subjective perceptions of risk. That in turn translates into a lower allocation to the stock market.
Here are a number of concrete steps to take to either (a) not look at your portfolio as frequently as you might otherwise, or (b) put constraints on your investment decision making so that you become less likely to make changes to your portfolio because of short-term volatility. This is akin to Ulysses asking his men to tie him to the mast to resist the Sirens’ songs. Possibilities include:
1. If you haven’t yet looked at your year-end brokerage statements, don’t. No good will come from doing so. Nothing that took place in 2018 was so unusual or unprecedented as to disrupt any sound financial plan, so staying the course is the only rational conclusion anyway.
2. Work with your brokerage firm, IRA or 401(k) sponsor, or adviser to both reduce the frequency with which they report your performance and to increase the length of the periods over which they do report performance. For example, you could instruct them to only report performance over periods of at least the trailing five years, and to update you only yearly. This simple step results in a significant increase in equity exposure, according to research conducted by Maya Shaton, an economist in the Banking and Financial Analysis section of the Federal Reserve.
3. Put things in perspective. For illustration purposes, let’s assume you had $1 million invested in your 401(k) at the beginning of last year, and that you were 100% invested in equities. Few retirees are fully allocated to stocks, of course. But even so, and assuming you follow the well-known 4% rule for distributions from your 401(k), last year’s decline translates into a monthly payout for 2019 of $3,180, versus $3,333 in 2018—a decline of $153 a month. And if, more realistically, you adhered to a traditional 60% stocks/40% bond allocation, your monthly payment in 2019 will be just $93 less than in 2018.
4. Invest in investment vehicles that have restrictions on when and how often transactions can be made, or that charge significant fees for such transactions. This is contrary to the nearly universal belief that restrictions and fees are a bad thing. But, ironically, their presence can discourage some of the more pernicious consequences of myopic loss aversion.
5. Don’t make any changes to your portfolio without first discussing the moves with an adviser, colleagues, or investment club. The mere discipline of having such a discussion can reduce the likelihood of your acting out of emotion rather than objective reasoning. The key thing is not to pick your discussants because they agree with you. You instead want to see if your intended portfolio changes can withstand critical scrutiny, so you need to pick them precisely because they are likely to disagree with you.
By the way, you should follow these steps during bull markets as well, when there is the opposite tendency to want to put more money into equities. But that discussion will have to wait until the market’s mood is a lot different than it is today.