When it comes to investing, we tend to remember the recent past.
Investing for and in retirement is far more behavioral than mechanical. Unsurprisingly, humans tend to respond to big, emotionally driven events. This is the very essence of recency bias: We have the behavioral tendency to assign more importance to events from the recent past, especially when it comes to investing.
Below, we’ll discuss how investors are better off taking a long-term approach.
A brief look at history
As of this writing, the S&P 500 is down 20% for the year, enough to make any retiree uncomfortable. Although the index has swung back and forth from bear market territory, many people are ready to dump stocks in an effort to preserve their wealth and avoid more pain.
Very few people want to see a rapidly falling market; this is entirely understandable. But it’s also not the time to let emotions dictate your investing decisions. As has been said before, the most effective way to enter periods like this is to develop a written financial plan with a pre-determined asset allocation — and then proceed to let things play out as they will
For a bit of reassurance, let’s look at a broad market fund — the Vanguard S&P 500 ETF — over the past decade, as opposed to just the last six months.
A nearly 200% gain is nothing to be upset about, and when put in context, it makes this year’s performance thus far look like a typical down cycle.
There isn’t any other way to say it: Seeing unrealized gains evaporate is painful. But when viewed through the right lens, it becomes much easier to stay the course and make prudent choices as long-term investors.
Some exceptions to taking a long-term view
Depending on where you are in your life, however, a long investing horizon may not be on the menu. If you’re close to retirement or already there, de-risking your portfolio to a more comfortable stock allocation is a no-brainer. Put another way, if you’re working with a portfolio of 70% stocks and 30% bonds, you might consider increasing your bond allocation if you’re unable to sustain any more losses in the short run.
You might also consider removing risky single stock positions to make up for a missing cash reserve. The upside to this is that while you’ll be selling stocks for less than what they were once worth, you’ll pay less in capital gains tax, and your portfolio will be less risky overall. Holding concentrated stock positions can be especially dangerous if we enter a longer-than-expected recession.
Updating your financial plan on an ongoing basis is also an effective strategy for managing the possibility of future downturns. Your plan should provide cover in all types of markets — not just a bull run or a lengthy bear market. A plan with only minimum-risk assets (like cash and short-term bonds) might not even match inflation, while a plan with too much risk (like a stock-only portfolio) can fall victim to whipsaw volatility.
If you’ve already sustained significant unrealized losses, it’s worthwhile to consider the makeup of your portfolio and think about rebalancing into index funds going forward. If you do decide to sell, a portion of your realized losses will offset your tax bill this year, while the rest can be utilized to offset future years’ taxes.
Avoid recency bias
As long as you’re comfortable with some up-and-down movement along the way, stock market investing has proven to be a reliable wealth generator. However, if you’re many decades from retirement, the recent downturn presents an opportunity. Stocks are now on sale — many are discounted by 20%, 30%, or more. If that’s you, it’s a great time to buy more stocks as you’ll receive more shares per dollar of investment.
Next, long-term investing is most effective alongside a healthy emergency fund. Without a cash buffer to help keep emotions at bay (and cover unforeseen expenses), there’s a greater likelihood that you’d need to sell stocks in a downturn. Doing so at the most inopportune moments can harm the long-run viability of your portfolio.
Finally, you might be content without taking additional market risk, even if it means facing inflation-related hits to your purchasing power. Depending on how much you’ve saved, this is also a reasonable choice if your temperament doesn’t fit with the current level of market volatility. To be a successful long-term investor, you’ll need to be comfortable with the idea that short-term losses can and do occur in the stock market. The long-term rewards will be there for those who stay the course.