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October 14, 2014 at 08:00 PM
A common goal for financial advisors is constructing a portfolio that successfully aligns with the investment objectives of the individual investor. Most advisors focus on constructing a traditional portfolio expected to generate a total return consisting of an optimal blend of current yield and capital appreciation.
But relatively few advisors take into account what we know about the emotional factors that powerfully influence how most investors actually behave. Unfortunately, this oversight can have a significantly negative impact on ultimate investment results.
Traditional portfolios and fear-based selling have caused many investors to miss the mark when it comes to long-term returns.
For some time, the standard model for traditional portfolio construction has comprised 60% stocks and 40% bonds. But in recent years, many of the portfolios constructed upon this model have not delivered the long-term returns anticipated. A significant factor in these results has been massive net redemptions in equity funds during market downturns, such as those of 2002 and 2008. (Source: Morningstar Direct.)
Unfortunately, investors usually do the wrong thing at the wrong time.
As the market statistics demonstrate, investors persistently buy when the asset price is high and sell when the price is low. (Source: DALBAR’s 20th Annual Quantitative Analysis of Investor Behavior 2014.) Since this approach is likely to promote losses rather than gains, why do investors usually behave this way?
Volatility evokes emotional reactions that often result in irrational investment decisions.
There is a strong temptation for fearful investors to “join the bandwagon” by selling assets during a downturn. Nothing tests an investor’s tolerance for risk like the stressful, real-world situation of a market downturn. In a perceived crisis, most investors simply respond emotionally and act accordingly. Driven by the fear of further losses, they fail to rationally consider the long-term impact of their impulsive decisions.
