To Do or Not to Do

| September 30, 2022

We know from studies of investors in the United States, Europe, and Asia that we are all prone to psychological traits that cause us to make the same investing mistakes. The first is the “house-money effect.” When markets go up a lot, investors increase their risk because they are “playing” with “the house’s money.” The house-money effect contributes to investment bubbles.

Another universal psychological trait is the “snakebit effect.” Declines from all-time highs lead people to become more risk-averse. Instead of buying on dips, investors sell on rallies. This reversal of behavior then worsens bear markets. We saw this in the real-estate crash of 2008/2009. The widespread use of index funds also expands the scope of declines and reduces discrimination between investment types, industries, or even individual companies or commodities. Ironically, the time to be afraid is when people are in the grips of the house-money effect and the time to increase risk is when others are snakebit. There is not a lot of math going on here.

People who buy on dips and sell on rallies do not really have an investment plan. We cannot escape their behavior, but we can use our plans to take concrete steps to improve our situations this year and create better outlooks for the future.

  • Widespread declines allow us to sell an investment at a loss and buy a substantially similar investment. For example, one large-company index fund can be swapped into a similar fund. Losses can be used to offset $3,000 in ordinary income. Losses and gains can be matched to offset each other. Unused capital losses can be carried forward indefinitely, creating more tax-efficient portfolios when the market rebounds.
  • We have held a number of investments with embedded gains that prevented us from moving to investments that better reflect the goals of many clients. Today’s declines allow us to better position clients’ accounts without serious negative tax consequences.
  • Because reversals are sudden, expecting to get back into markets in time is unrealistic. Regular rebalancing allows us to buy some shares low and sell other shares high. We are unlikely to be either entirely right or entirely wrong, which is the fatal flaw of market timing. Rebalancing also allows us to take advantage of higher interest rates.
  • The availability of good bonds for the first time in years gives us the opportunity to ladder maturities. A laddered portfolio is one where a percentage of bonds mature in the same months or years. For example, 20% could be put in 1,2,3,4, and 5-year bonds. When rates fall, we will still have bonds that pay a higher rate. When rates rise, maturing bonds allow us to lock in the longest rate. This is a long-term strategy that requires discipline and patience. We can implement it in both funds and individual bonds.
  • Turn off the cable-news channels where mundane people make shameful profits sowing fear and distrust.

The next bull market is likely to begin before the end of the next recession. If the Fed acts with resolve, those who are prepared today will be set up to take advantage of it. I believe that Fed Chairman Jerome Powell is now free from the immense political pressure that haunted him last year. Of course, we can never be certain of future events, which is why we need to have good plans implemented with discipline.

* Nofsinger, John R. The Psychology of Investing. Sixth ed., Routledge, 2018.