Psychological Factors Magnify and Prolong the Negative Impact of Market Losses

John J. Hohn and dog Jessie

Wealthy people can take losses in their retirement portfolios lot easier than middle-income households who have plans for every dime that they have invested. But investors with large portfolios—portfolios that could be reduced by half and still not put their retirement in jeopardy—often fail also to employ coping strategies that help in rough times.

In this series, we looked at the external risk tolerance factors take should guide an investor in choosing an asset allocation strategy. The other leg of choosing the appropriate level of risk is highly personal. Some people take losses in stride. Others magnify their impact by what they read into events.

A golfer returns home after a bad round ranting:

“I will never learn this game.”

“I just don’t have any talent at all for this game.”

“I was stupid to take it up in the first place.”

Negative comments like these, although understandable and human, will not help the golfer improve. They only magnify the impact and unhappiness of doing poorly on a particular day.

“I’ll never figure this damn market out?”

“The minute I move into something, you can figure it will start losing.”

“You hear these other guys do well, but it never works out for me.”

Golfers or investors. It doesn’t matter. Reactions like this are not reality based and not helpful. If anything, it makes it more difficult to come up with an appropriate strategy for winning—on the links or in the market.

The first step, as explained in earlier posting, is to put the loss into perspective by measuring its impact on the plan for retirement. Doing so deals with the effects of the loss rationally. Nothing intensifies fear more than being up against the unknown. So the first step is to eliminate the unknowns, reduce the fear and the panic, redefine the problem in concrete terms and make the appropriate adjustments. Delays in taking these steps prolong the stress and discomfort.

Sometimes, however, putting the loss in perspective in terms of time or dollar amount is not enough, even when the impact is inconsequential. This usually happens when money is no longer money to the investor.

I inherited a couple as clients when the advisor with whom they had been working transferred to another firm. The previous advisor was opportunistic, played hunches, and eschewed many of the basic principles of portfolio management. As a result, his clients lost money, as was true of the couple—an emergency room physician and his wife—who were assigned to me.

They were concerned about their losses. I showed them that their retirement plans were still very well funded, but as I began to show them a more disciplined and structured way to reach their goals, they began to see the difference between my approach and the previous advisor. They wanted to know why he did not do as I did. They blamed the office manager for not supervising him more closely. They were angry about being misled. The blamed the firm for not having policies in place that prevented losses because of what they regarded as an advisor’s incompetence.

Sometimes, as in the case of Rene McAllister in the novel, Deadly Portfolio: A Killing in Hedge Funds a client may have a legitimate complaint against an advisor. Rene’s advisor, Morrie Clay, acted illegally. He purchased securities without her consent and tried to cover up his errors. Cases like hers needed to be reported whenever a client becomes suspicious of mishandling in an account. The firm will conduct an even-handed, fair investigation. However, when the client authorizes all of the changes the advisor recommends, when the client has ample opportunity to compare account performance against tradition benchmarks such as the Dow Industrial Index or the S&P 500, and when the client has received all of the required reports and statements, the client will be viewed as well-advised and as a participant in the decisions that we made in managing the account. The client, in other words, is expected to accept some of the responsibility for the management of the account and the results achieved.

The clients I inherited did approve all of the decisions that theprevious advisor made. They were advised in regular meetings about the status of their holdings. They had ample time to check against readily available records and reports to determine if the performance of their account was keeping pace with the market.

In working with me, however, rather than look ahead down the road, their gaze was arrested by their losses in the rear view mirror. When they did well, they whined about how much better off they would have been without those losses. When they suffered a setback, they griped that the earlier losses made matters much worse. I reached a point where I could almost predict what they would say:

“Just think where we would be now if we had not had those losses under other guy.”

Or, “The current losses would not look this bad if we still had the larger cushion that those earlier losses took away”

Rather than recognize that they were now doing well, that they benefited in changing advisors, that they also had gains under the other man that they should take into account, and that they could still be working with him and be none the wiser, they enshrined their losses. They could not think about their portfolio without thinking about their losses.

Financial advisors are a lot like doctors. They will not admit that another professional has mishandled anything. Never expect that one will, especially if the predecessor worked for the same firm. In this case, no matter what we worked out as a plan, their subconscious objective each year was to replace those losses—to make so much that they would never think of them again. It was an impossible goal. The losses would always be there. Like a pothole in the road that was patched over with buckets of asphalt every day and yet reappeared in their thinking the very next morning at the same painful psychological depth.

Losses are permanent. In and of themselves, they are as meaningless as a detour in the road. They may slow you down. They may make you uncomfortable. But they are unavoidable. Never invest if you think that you can avoid losses. You can’t. Here’s an illustration to make the point.

Let say that you planned to drive to a town 200 miles distant and you want to get there by 6:00 p.m.. You leave at noon because it would be nice to get their early, look around a bit and relax. You like know that you have plenty of time so you decide to drive at an average rate of 60 miles per hour. A simple calculation tells you that you will be on the road about 3 and half hours. You encounter a detour that slows your rate of speed down to 30 miles an hour for the first hour and you realize that you are 30 minutes behind you intended schedule. Arriving at the at the supper hour  is no longer the goal. You have lost time and you will need to spend more than three hours in the car. You don’t like being forced to accept those conditions. The driving may be somewhat more tiring and it may be less comfortable in the car for the extra time that it will take to get there.

You decide, therefore, to drive the last 2 hours as fast as you need to make up for the lost time. To cover the remaining 170 miles in 2 hours will require achieving an average speed of 85 miles an hour. You will still arrive around 3:30. You still will only spend three hours in the car. The delays of the detour will no matter any more. Besides driving faster is exhilarating. You ignore that the increased speed is inherently more risky even under the best of driving conditions. You ignore that you risk being be pulled over by the highway patrol, fined and delayed even more. You ignore that  you have ample time, 2 and half hours even after your delay to reach your destination.

I guess that there are drivers out there who would make the same decisions, but let’s hope they are few. Most would look at the choices in the illustration and simply say that you forgot your initial objective and took on way too much risk.

Never adopt a riskier asset allocation in the hope of satisfying psychological goal.

Every day is a new day. Every year is a new year. Wipe the slate clean and do as well as you can. Your current advisor, if you use one, or you, if you are working alone, can only make whatever gains are available in the market going forward in time.

The losses that have the longest lasting impact on your portfolio are those that you allow to influence your better judgment, lead you to admit too much emotion into your decisions and prompt you to abandon a disciplined and structured plan approach to managing your money. Cutting your losses may mean staying positive in your thinking and disciplined in your planning.