Understanding your emotions, and learning to manage them, is a great advantage when investing. Much of portfolio theory and investment research is based on what a rational person would do. But people are not rational, particularly when it comes to their money.

Nobel prize winner Daniel Kahneman and Amos Tversky studied risk behavior and applied it to the economics of investing. Their research forms the basis of behavioral finance and how people apply mental shortcuts to investing as opposed to an analytical and deliberate strategy. Being thoughtful about your investing, even when you are afraid, can lead to long-term gains.

Let’s focus on the emotional side of portfolio management.

Risk Preferences

Before investing, we spend time discussing your comfort level with risk so we can better understand how you may react under different market circumstances. This is where your emotional response to the ups and downs of the market really come into play. When markets fall and you are excited because you have an opportunity to invest, you probably have a high risk tolerance. If you get scared during market downturns and feel like the sky is falling, you are most likely in the low tolerance category.

Additionally, we consider your timeline for investing. If you need short-term funds, we would want to invest conservatively, or make sure you have cash on hand. For longer term needs, we may invest more aggressively. 

Another part of your risk profile is your capacity for investing. Think of this as how much you can afford to lose. For example, if you are retired with a small income and only $100K in investments, you may want to be conservative as you cannot afford to lose those funds. On the other hand, suppose you have a large steady pension along with Social Security and real estate income. If you have the same $100K in savings, you may be able to invest more aggressively as a loss would not have the same negative impact.

Finally, education helps you become comfortable with stocks and investing. Learning increases your understanding and your comfort with the risks in all markets.

Manage Behavior

Our behavior often works against us when investing.

When we listen to the news headlines, we might hear that stocks are going to soar this year. Or, more often, the markets are going to crash. Maybe you feel like you have a strong insight into a particular business sector, so you focus only on those stocks. These ideas make us want to buy or sell in an attempt to take advantage of the business cycle. However, this is hard to do.

You need to manage your emotions when you are investing. Focus on the things you can control, not on markets and news. Don’t worry about how a stock performed yesterday. It may react very differently today. 

A client told me that when Trump was first elected president, she sold out of the markets because she was afraid everything would crash. Stock markets were booming. So, when Trump was elected for his second term, she felt like the economy would be great, so she purchased tech stocks. The magnificent seven declined about 11% in his first 100 days. Her emotions failed her investing decisions.

It’s difficult to decide the right time to sell out of stocks during a business cycle. Often, we see clients sell out of fear. When clients want to do this, we have to ask: if you get out now, how will you know the right time get back into the market? It’s even more difficult to determine when to buy back in. Essentially, you would need to be correct twice without the benefit of hindsight. By having a diversified portfolio calibrated to your big picture goals, you do not need to focus on market timing.

One of the benefits of being well diversified is not having to react to markets. We encourage our clients to tune out the noise they hear from the media and pundits and continue on their current investment track. 

One tool we use to keep your portfolio on track is a simulation of your investment results with hundreds of potential variables. This allows us to factor market changes into your investments so you can be more confident that your plan will withstand daily volatility changes, regular market price pullbacks, and random catastrophes. Your plan is built to withstand those. While we don’t know exactly what it will look like next time the market is shaken by volatility, we do know it will happen and we have a plan for it.

Embrace Patience

Investing and trading are two different activities. Investing is boring – like watching paint dry. You set up your investments and wait. Changes are made when your circumstances change. 

Trading, however, is exciting. Look at websites such as CNBC.com and YahooFinance.com. They are busy, have lots of details and numbers, and they let you know what’s going on. Now, look at a sports website such as ESPN.com or YahooSports.com. They are busy, have lots of details and numbers, and they let you know what’s going on. Now check out Stake.com, a gambling website. Same thing. These sites are all designed to make your interest into a game of chance.

Trading is a game. Investing is a long-term strategy. 

Markets will work for you, but only when you are patient. Remember – it’s not timing the market, but time IN the market. We design portfolios for the long term and encourage patience.

Discipline

Creating a portfolio that works for your personal situation is a thoughtful, rational process to meet your personal goals, reduce costs, and diversify across multiple investment categories. This is the first step, which then needs to be balanced with the emotional side of investing.

Maintaining your portfolio requires discipline to stay on track when times are uncertain and markets are volatile. Having a rational portfolio that fits your risk comfort level is the first side of the equation. Maintaining the discipline to keep your investing on track over time is more difficult as it means taming our emotions during periods of exuberance and turmoil. Keeping the rational and the emotional balanced is the key to success.

Pamela J. Horack, CFP® of Pathfinder Planning LLC provides personal financial planning advice and investment management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.

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This is where we help.

We are here to help clients understand how their portfolios work, and educate them on markets and products.

Much of portfolio theory and investment research is based on what a rational person would do. The “rational person concept” helps us build portfolios by assuming that investors act in their own interest, make logical decisions, and have access to relevant information.

Let’s focus on the rational side of creating a portfolio. 

Goal Based Strategy

We have always been a “planning first” firm. To us, this means that we create a financial plan first, and then determine the products or investments needed. This step-by-step process allows our clients a sense of financial wellness and gives them clarity to see how products and investments fit into their overall picture. Having the big picture prevents clients from being “sold” products that are not the right fit.

Understanding your core values allows you to live your fullest life. When your finances match your ideals, you can live in alignment with the things that are important to you. Your values match your goals, and your goals match your passion and the life you want to lead. All of this is captured in your financial plan.

Having a portfolio that aligns to your goals and values gives you more assurance that you can meet your near term and long-term goals, while not sacrificing your family’s safety. This focus grounds your investing. When news is bad or things change, you can always go back to your plan and know that your investments have been factored in your overall direction.

Our younger clients are investing for retirement. This important goal is far in the future, and they understand the value of investing for their future life. For many of us, it’s drilled into our head – save, save, save.

Our retired clients, on the other hand, focus on the dual goals of not running out of money during retirement and minimizing taxes. This requires a different mindset, as well as a different type of portfolio. 

Each of these circumstances has clients investing differently to meet their goals, so their overall  plan affects their portfolio construction. 

Low-Cost Investing

When thinking of low-cost investing, most people immediately equate it with passive investing. While passive investments are inexpensive, it is not a “set it and forget it” solution.

While the passive investing approach hints at an index approach—like the S&P 500 or the Bloomberg Aggregate Bond Index—it doesn’t mean that there are never any changes to the portfolio or to the individual investments. While the individual investments may rebalance securities anywhere from one to four times a year, each fund may need to be replaced depending on markets, management, or your personal needs.

Choosing and Maintaining Low-Cost Investments

There is actually a lot that goes into selecting and maintaining a low-cost type of portfolio:

• We start with the rational process of creating the right asset allocation mix, which is done during the planning process.
• Next, we choose appropriate investments, such as mutual funds or ETFs, which meet your goals.
• We then allocate the right type of investments to the right type of accounts, known as asset location, to maximize growth and minimize taxes.
• We monitor your account over time and make asset allocation adjustments as needed.

We believe that the average person cannot outguess the market, which is why holding an index of funds for the long term is important. Markets tend to be efficient and move based on known information, so it’s extremely difficult for a person to make trading decisions that out-guess the market. By the time you know the information, it has already been factored into market prices. 

While we always start with a core set of passive investments, (often index funds,) we may use active satellite investments to boost performance. These funds may hold fewer, more targeted securities, which may be traded more often depending on the goal of the fund. Low fees are a hallmark of passive index funds. Active funds often have greater costs to account for greater management and trading fees. These funds can produce outsized returns depending on their purpose and structure.

Remember: the lowest cost funds do not always make the most efficient portfolio for your needs.

Diversification

There are multiple levels of diversification, which is a fancy word for “don’t put all your eggs in one basket.” 

First is your asset allocation. This is dividing your funds between stocks, bonds, and cash.

Next, each piece of your asset allocation is divided into smaller pieces. For example, stocks can be divided into US and International. US stocks can be further divided into asset classes of growth stocks, value stocks, mid-cap, and small cap.

By the time you get to the level of individual stocks, your overall pool of money is diversified across multiple asset classes and individual securities. You want to diversify across the investment universe. 

Diversification does not mean having multiple accounts at different banks and brokerages. That is just spreading money around and can be more expensive to track and maintain. It also does not mean purchasing investments that are unfit. If gold or bitcoin are not a fit for your plan because they are too risky, then you don’t need them for your portfolio to be diversified.

When a stock market index, such as the S&P 500, decreases, a diversified portfolio of 60% US and Foreign stocks along with 40% US and Foreign bonds will perform differently than the index. For example, this chart shows that when the S&P 500 was down 3.26% over a four-month period, a diversified 60 / 40 portfolio was up 0.24%:

Taking a diversified approach to investing allows you to take advantage of market upswings while having protection when markets are down. 

Discipline

Creating a portfolio that works for your personal situation is a thoughtful, rational process to meet your personal goals, reduce costs, and diversify across multiple investment categories. This is the first step, which then needs to be balanced with the emotional side of investing.

Maintaining your portfolio requires discipline to stay on track when times are uncertain and markets are volatile. Having a rational portfolio that fits your risk comfort level is the first side of the equation. Maintaining the discipline to keep your investing on track over time is more difficult, as it means taming our emotions during periods of exuberance and turmoil.

Keeping the rational and the emotional balanced is the key to success.

Pamela J. Horack, CFP® of Pathfinder Planning LLC provides personal financial planning advice and investment management for a simple fee to young adults and working families in North and South Carolina through group classes, one-on-one planning, and ongoing advice.

The post The Rational Side of Investing appeared first on Pathfinder Planning.

Your 401(k) or 403(b) accounts are a smart place to store your retirement money — there’s no disputing that. However, simply directing a percentage of your paycheck into it every month and expecting the culmination of funds to support you through your golden years is not enough. 

You need to understand how your investments, the plan’s fees, and any employer match play into putting you on track for your retirement goals.

If you own a television (or have been near one at any point over the last decade), there’s a good chance you’re familiar with the phrase ‘Set It and Forget It’. In fact, it was this catchy slogan — popularized by Inventor and TV pitchman Ron Popeil — that grew sales for his Ronco rotisserie oven to well over 8 million units in the United States alone.

Here’s the thing, though. 

While “set it and forget it” is a great idea in the kitchen, it is far less effective when it comes to your retirement savings. With that in mind, here are four key things to know to get the most out of your 401(k).

Contribution Behavior

A study carried out at Harvard and Yale revealed some astonishing financial behaviors in retirement-age participants. 

In the study (titled $100 Bills on the Sidewalk: Suboptimal Investment in 401k Plans), employees over 59.5 years of age were unaffected by the amount their employers were willing to match in their 401(k) plans. 

Not only did the participants ignore the amount of their employer contribution when deciding how much to contribute themselves, but they also did not show any significant changes in behavior if there was no penalty for early withdrawal. 

On average, these employees missed out on $507 of “free money” by not taking advantage of their employer’s matched contribution.

So, what does this all mean? It means that if you are not participating in your company’s retirement plan, you are missing out on money.

Based on available research, there are two common reasons most people aren’t getting back as much as they should. The first is procrastination and the second is having too many choices within the plan. 

Thus, if employees are given a deadline for signup and a reasonable number of choices, they are more likely to save.

Fortunately, you can make this work for you.

Set a Deadline for Yourself  

It sounds easy to set a deadline, but many people don’t like to think about saving for retirement. They’re often caught up in the here and now of daily expenses, short-term savings, and emergency funds. However, if you want to get the most out of your 401(k) plan, you need to set a deadline for yourself and get the ball rolling.

This means that you should set a reasonable date to signup with your employer and begin making contributions. This will push you to start making contributions earlier. The sooner you start, the more you stand to gain down the road. A great time to do this is at the end of the year when you commit to your medical and other benefits.

If you already have a 401(k) plan, you’ll still need to decide when to start making contributions. For example, you could say, “I’m going to contribute 5% of my pay in my company’s 401(k) plan beginning in July.” Done! Now, go online and get it done!

Review Your Investment Choices

Every 401(k) plan gives you investment options, but no two plans are the same. You may have a lot of options to choose from or you might have just a handful. Either way, you should take the time to review what’s available to you and make an informed decision.

If you feel overwhelmed with too many choices, you don’t need to make a decision on your own. You can always reach out for guidance. Saving for retirement is extremely important, so you should never make any decision unless you feel well-versed in your options. 

That said, if you’re comfortable making the selections on your own, go for it!

Maximize Your Employer Matching Contributions

Not all employers offer matching contributions, but if yours does, you should absolutely take advantage of it. Matched contributions are literally “free money” for your retirement. So, if you contribute the maximum amount possible to your 401(k) every year, you will get the maximum amount in matched contributions as well!

In addition to contributing the maximum, you should also start contributing as soon as possible. You can’t start taking advantage of matched contributions until you make contributions yourself. 

So, what are you waiting for? Your Financial Mom is telling you to start now!

Pathfinder Planning LLC is a registered investment advisor in North and South Carolina. For more information, visit www.pathfinderplanningllc.com. 

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