Market insights and analysis

How dynamic, risk-managed investment solutions are performing in the current market environment

2nd Quarter | 2021

Market insights and analysis

rss

Updates on how dynamic, risk-managed investment solutions are performing in the current market environment.

Don’t let your heart rule your investments

By Peter Mauthe

This week, I want to talk about a well-documented pattern of investor behavior that does not serve their best interests: letting emotions rule investment decisions. We originally posted a version of this article last year just before the COVID crash.

One of the first basic rules I learned about investing was “Buy low and sell high.” Seems simple, right? In theory, yes. In practice, maybe not.

Buying low means putting more money on the table when the market is on the decline—a time when you may feel least like taking on more risk. Selling high means getting out of the market when all of your senses (not to mention the financial media) are telling you the sky’s the limit.

When emotions take over, bad things can happen

In our webinar, “The only forecast that matters,” behavioral finance coach Jay Mooreland did a great job of putting this investor behavior in perspective. He said that our brains are driven by confidence, not accuracy. He also cited a study by CXO Advisory that showed that only 47% of over 6,000 “expert predictions” between 2005 and 2012 were accurate. This is particularly significant because the media tends to promote bearish market experts at market lows and bullish market experts at market highs. Investors are inclined to have confidence in those deemed “market experts” whether they are right or not.

So how do investors’ emotions work to their detriment in these cases? When an investor is already experiencing anxiety during a bear market—a good time to buy low—bearish market experts may give that investor confidence that the anxiety he or she feels is appropriate. This may stop him or her from taking advantage of that “buyer’s market.” Conversely, when an investor is experiencing elation during a bull market that is hitting high after high—a good time to sell and capture gains—bullish market experts may reinforce that investor’s feeling that the good times are never going to stop. Based on this confidence, the investor may even throw more capital into the market (buy high) when he or she should be selling. Like investment analyst Benjamin Graham always says, “The investor’s chief problem—and even his worst enemy—is likely himself.”

This is why we at Flexible Plan Investments rely on portfolios driven solely by strategies that are based on rules, not emotions. We have no investment committee debating what we might do on any one day. Instead, we objectively analyze real-time market data and draw investment conclusions based on market history.

We do not predict or forecast. We do not react emotionally to market action or economic developments. We do respond in a way history has shown is the most beneficial to investors.

Making sentiment work for you

Disciplined investors can make other people’s emotions work for them. In the field of technical analysis, there is an area of study known as sentiment, which explores the overall attitudes of investors toward a particular market. There are many sentiment indicators designed to signal when investors and market experts are at the extremes of bullish and bearish beliefs. When extremes in sentiment are reached, historically, going against the crowd has shown to deliver the best outcome for investors.

The following chart shows an example of an indicator based on the percentage of AAII (American Association of Individual Investors) members who responded to a weekly survey indicating they were bullish. High readings in this indicator are generally associated with market tops—selling opportunities. Low readings in this indicator are generally associated with market bottoms—buying opportunities. A disciplined, non-emotional investor could take great advantage of these swings in market sentiment.

Unfortunately, not all of us are disciplined investors. When acting on emotions, we typically make poor investment decisions. Many studies have shown that mutual fund investors often buy the most near market tops and sell the most near market bottoms. In doing so, they end up compromising their returns.

How to take emotions out of the investment equation

So what’s the solution? How can investors avoid letting emotions get in the way of reaching their financial goals? At Flexible Plan, we address this by taking emotions out of the investment decisions completely. We develop investment strategies that can respond objectively to trends and extremes in price action in all three of the asset classes in which we invest: stocks, bonds, and alternatives. Our risk-managed core strategies are designed to provide portfolios with objective, rules-based exposure to all three asset classes. A well-designed core will generally provide a portfolio with approximately 80% or more of the desired portfolio return and risk reduction.

Our explore strategies complement our core strategies by allowing investors to target a specific asset class in order to “fine-tune” their risk management or enhance return. All of our core and explore strategies are rules-based. Every rule set is designed to objectively exploit some inefficiency in the market. The more inefficiencies that can be exploited within a market by a group of rule sets, the more opportunities a portfolio has for profit. While the rule sets built into each strategy are not designed to forecast or predict, they are designed to increase an investor’s probability of success.

Another way we help investors take emotions out of the investment equation is by allowing them and their financial advisers to “delegate” watching the market every day (another source of investor stress, according to Jay Mooreland) to us. Flexible Plan watches all of the markets in which we invest—all day, every day. We are continuously ready to take the action our many rule sets require. This takes the burden off both the adviser and the investor, giving them more time to identify and work toward those financial goals that allow investors to live their best and most enjoyable lives.



Comments are closed.