Investing 101: Don’t Let Story Time Dictate Your Actions
People have a natural impulse to hear and tell stories. This desire is formed at an early age as parents read bedtime stories to their children, and develops throughout adulthood with various forms of media. Unfortunately, storytelling plays a major role in the financial markets, which more often than not, only serves as distracting noise for investors.
All three major U.S. Indices are in negative territory this year. Last week, the Dow Jones Industrial Average and S&P 500 both fell more than 2 percent, while the Nasdaq dropped 3.1 percent to post its worst weekly decline in almost two years. In fact, some of the biggest leaders of the bull market have turned into laggards almost overnight. With stocks struggling to keep their impressive momentum from last year, there are plenty of stories to be found that attempt to explain the move.
The most obvious narrative involves a mixture of central bank tightening and an overvalued stock market. The Federal Reserve appears to be set on dialing down its monthly bond purchases at every policy meeting — raising fears of reduced liquidity and higher interest rates. Meanwhile, stocks have rallied for five consecutive years and are inducing flashbacks of bubble-themed finales. In the end, history shows that investors will hear whatever story is playing the loudest.
As the table below shows, investors typically become distracted with either greed or fear. Between 1993 and the market peak in March 2000, investors’ allocation to equity funds almost doubled to 62 percent, according to Vanguard. Naturally, greed was the strongest toward the end of the major move with nearly $400 billion rushing into the dotcom bubble in its final two years — regrettably. Stocks across the board then fell sharply and sent investors running for the hills. Bond funds received $221.5 billion in the two years leading up to 2003, just in time to miss a 53 percent rebound in stocks over the following two years.
Once again, investors who were caught up in the narrative did not receive a happily-ever-after ending. An astounding $424 billion flowed into stock funds in the two years preceding the peak of October 2007. The top was followed by the worst financial downturn since the Great Depression, and the fear generated from the crisis kept millions of investors on the sidelines for years as stocks climbed higher.
“Many investors — both individuals and institutions — are moved to action by the performance of the broad stock market, increasing stock exposure during bull markets and reducing it during bear markets,” explained Vanguard. “Such ‘buy high, sell low’ behavior is evident in mutual fund cash flows that mirror what appears to be an emotional response — fear or greed — rather than a rational one. Not only do investors in aggregate allow their portfolios to drift with the markets, but they also tend to move cash between stock and bond investments in patterns that coincide with recent performance of the equity market.”
Where does that leave investors today? The current bull market in stocks officially turned five years old last month, and an argument could be made either way about its longevity. It is the fifth-longest bull market since 1928, but would have to climb higher without a 20 percent correction for another seven years before surpassing the longest bull market that ran from 1987 to 2000, according to Bespoke Investment Group. Most would agree that this is very unlikely, but it is certainly within the realm of possibility.
Instead of worrying about headlines and the daily narrative, investors should focus on financial aspects they can control. You cannot influence the Federal Reserve’s policy decisions or the events taking place overseas, but you can make sure you are taking the long-view on your financial goals. Create a clear, measurable, and attainable plan that reduces the odds of letting the market incite fear or greed in your investing decisions.
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