The Rational Investor
Financial markets are often described as being ruled by two emotions: greed and fear. For a few years after the 2008-2009 financial crisis, fear ruled the day, as individual investors made massive withdrawals from stock mutual funds and sought safety in bond funds.1 More recently, as markets reached new highs,2 investors reacted by pouring their money back into stock funds.3
Do emotions drive your investment strategy? If so, be aware that failure to be rational in your investing decisions is not constructive. It's a short-sighted mistake that can sink your efforts to build lifelong financial security. What is constructive is good planning, backed up by the discipline to follow through for the long term.
Make a plan - and stick to it.
If you're tempted to make dramatic emotion-led investment decisions, your plan will spell out why you need to stay diversified and on track with your allocations. Moving all your retirement assets into bonds, for example, may temporarily reduce your fear of losses, but it also may reduce your chances of hitting your retirement goals. Moving all those assets into stocks, by contrast, could cause problems if there's a big market downturn as you near retirement.
Your financial plan should clearly describe your short-, medium- and long-term financial goals; your investment time horizon; and your risk tolerance. This information helps to determine your asset allocation and the amount you need to save toward these goals.
Taking the time to make a written plan can help prevent many short-sighted errors. For example, if you're tempted to increase discretionary spending even though the tradeoff is a reduced savings rate, you can refer to your plan for a reminder of why you're making sacrifices now.
Not looking past today? Think ahead.
The emotional pull of immediate gratification can pose a serious threat to spending plans and long-term investment strategies. When you choose rewards now over rewards later - when you purchase a desired item knowing it will bust your budget, for example, or chase investment returns without regard to your planned asset allocation - impulse, not self-control, drives your short-sighted decision.
When estimating your future needs, it's natural to think in terms of your current needs. But that present-day bias ignores how your lifestyle - and expenses - may change.
If you want to fund your children's college education, don't base your savings on today's tuitions. The cost of education is rising much faster than inflation. Health care costs are rising faster than inflation, and your need for health care generally increases as you age. That's why it's best to study cost trends when you set (or adjust) your financial goals. If you're at risk of falling short, consider boosting contributions to your retirement account - or increasing your allocation to more-aggressive investments, if your risk tolerance allows it.
Your time horizon is your lifespan.
Life expectancies have lengthened over generations. A man reaching age 65 today can expect to live until age 85½.4 A woman turning age 65 can expect to live until age 87.7. And those are just averages: About one of every four 65-year-olds will live past age 90, and one out of 10 will live past age 95.5
Conventional wisdom holds that retirement investments should become more conservative as we age. But given today's lifespans, most retirees are still long-term investors, with an investment time horizon of 20 years or longer. Retirees (and pre-retirees) who forgo diversification and sell all their equities will miss out on stocks' long-term growth potential and risk losing ground to inflation.
Think through your long-term financial plan. By applying a rational approach to setting your goals and your strategy for achieving them, you're better prepared to resist making short-sighted decisions based on emotions.
For a calculator to help with your scenario-based planning, visit janus.com/goalplanner.