A famous football coach once said, “You’re never as good as you think you are when you win, and you’re never as bad as you feel when you lose.”  Investors should modify that quote just a little bit to help them maintain perspective and stay the course with their investing plan.

It is the natural tendency of an investor to assume that his account balances are what he really owns.  Aside from the fact that the government owns some as-yet-unclear portion of your tax-deferred accounts, this is a very misleading attitude that leads to poor financial decisions.  The “wealth effect” is well-known.  People spend more after a run-up in stocks and real estate prices.  At its worst, people use their home equity as ATMs, pulling it out to spend it on consumer items.  This is a behavioral error you should work hard to avoid.

Bull Markets And The Wealth Effect

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Assuming a long-term investment horizon, the reality is that near bull market tops you have lower expected future returns or less money in the account than you think you have (same thing really for a long-term investor).   Don’t spend too much time congratulating yourself on your investment acumen and counting your wealth.  A good percentage of it, perhaps even half of the money you have invested in risky assets, is almost surely going to disappear at some point in the next 5 years.

An even worse tendency on the bull market side is the idea that your account balances have gone up dramatically in the last few years because you’re a brilliant investor. As John F. Kennedy said (admittedly in a different context) a rising tide lifts all boats.  Over the last 5 years, you could have bought just about any asset and done great.  US Stocks are up 19% a year, International Stocks are up 12% a year, Large Growth Stocks are up 20% a year, Small Value Stocks are up 20% a year, and REITs are up 17% a year.  Even recent losers like Emerging Markets (up 14% a year), Nominal Bonds (4% a year), TIPS (5% a year), and Gold (7%).  Heck, even home prices are up 1% a year for the last 5 years, and that includes an 18% drop in the first two of those five years.  Meanwhile, inflation has been very low at 1.6% the last five years, so the vast majority of those exceptional returns have been real, after-inflation returns.

Selling Out At Market Lows

Lots of investors, including many physicians I know, sold out at the market lows of 2008-2009.  They looked at their recent losses and compared their balances to how much they used to have and how much they needed in retirement and decided they could not afford to lose anymore.  Perhaps if they remembered that they really didn’t have as much as they thought they had in early 2008, nor as little as they thought they had in March 2009, they would not have done so.

Market Timing Still Doesn’t Work

Now, although I expect some significant losses to occur in the next few years, I’m not advocating that you somehow try to time that event.  I have no idea if it will occur this year, in 2016, or even in 2018.  But it will occur.  You will lose some money in bonds.  You will lose some money in stocks.  You will lose some money in real estate.  You will lose some money in precious metals.  The only reason to change your asset allocation (investment plan) is in response to changes in your need, ability, and desire to take risk.

I think it is okay to play around on the edges, perhaps a 5% variation in your stock to bond ratio, perhaps putting a little more money into paying down debt and a little less into your investment portfolio, perhaps rebalancing a little more often etc, but realize that these little moves are probably just as likely to cause you to lose money as to gain it.  Don’t believe me?  Write down the little changes you make and the reasons you made them and go back in a year or two and see how clear your crystal ball was.  It might satisfy an urge to tinker, however.  Better to make little mistakes than big ones. The reason that market timing is so difficult is that not only do you have to figure out what will happen in the future, but you also have to time two events at least relatively successfully- an exit and an entrance.  This is surprisingly hard, even for an unemotional Spock, but add in some of the emotional effects caused by greed and fear and it is nearly impossible.  As John Bogle said about market timing,

“After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.”

Stay The Course

So what should the investor do?  The same thing he always does.  Stay the course.  If you’re still a decade or more away from retirement, just stick to your plan.  Keep your 60% (or whatever) stocks in bull markets and in bear markets.  Don’t get greedy and abandon bonds, especially out of an irrational fear of some bond bear market.  Do not start spending more or buy a bigger house because your balances seem large.  Remember a significant chunk of your investment account isn’t really there.
If you are very near retirement (at the point where a bear market in the next 5 years would cause you to have to work longer), take a look at your need to take risk.  Perhaps this recent run-up has put you into a position where you no longer need 8% returns to meet your goals.  If you no longer have a big need to take risk, perhaps this is one of those times to dial back the risk in your portfolio a bit.  Pay off your mortgage and student loans with your new contributions.  Those returns are guaranteed no matter what the stock and bond markets do.  Donate appreciated shares to charity; even if the market goes down later you will still get the full tax deduction, and in the meantime, your money can do some good in the world.
What do you think?  What have you done to combat the wealth effect in bull markets and in bear markets?  Comment below!