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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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This temptation to sell or, on the flip side, to divert from your plan to chase a hot trend, is another risk of investingThe stock market is not a place to fool around with extreme risk. If you as an individual are going to invest your and your familys money in the market, you should subject it to only reasonable risk. Reasonable risk is the degree of risk you need to take to give yourself the chance to reach your goals, and not an iota more. If you estimate it takes an 8 percent annual return for the next five years to reach a short-term goal (and Ill talk about how to figure out the right percentage for you in the next chapter) then your game plan should be comprised of investments that together offer the best chance of providing you with that 8 percent return. Any combination of choices that proves even one bit more risky than that, and you are needlessly subjecting yourself to the possibility of losing your money. Think of it like taking a trip. Say you have four days to drive 1,000 miles to your destination. If you drive 60 to 65 mph, youll reach your destination in the time allotted. Youll incur the risk of getting behind a wheel and the risk of driving 65. But because driving about 65 mph is necessary to your goal, and because a four-day trip is a reasonable goal, the four-day plan poses reasonable risk. Say instead youre eager to drive 80 to 90 mph. Youd arrive a lot quicker and perhaps would have a less tedious trip. But youd boost your chances of getting a speeding ticket or having a serious accident. The higher-speed driving subjects you to risks that you simply do not need to accomplish your goal. Likewise, euphoric tech returns of 98 or 99 percent may be thrilling, but a subsequent crash is not. Risk Tolerance: The Risk That You Cant Handle the Risk If youre still with me, then youre thinking that in the next chapter youre going to figure out your goals, figure out how much risk itll take to try to achieve those goals, and then go for it. Youll venture forth into that five-year time horizon with the conviction that youll have the courage to keep your commitment. Youll go ahead and invest. Now, what if three months later the market tanks? And tanks deeper? And now violence erupts overseas, and stocks drop again. A little rally perks up, but then oil prices spike, and its six months later and youre down even more. Then the memorable words of Alan Greenspan, the head of the U.S. Federal Reserve, ring loud and clear. By mid-2002 he had declared that the country had shifted from a mood of irrational exuberance to one of infectious greed. Corporate capitalisms integrity appeared to have broken down and the markets fell further. At a time like this, the risk of losing money has materializedyou have far less than what you started with. Money that took you months or years to earn has evaporated. Its gone. The optimist in you is trying to keep focused on that other risk of missed opportunity, the risk of not reaching your goals in 20 years if youre not in the stock market today. But as your mutual fund statements turn a deep red, youre tempted to bail out. This temptation to sell or, on the flip side, to divert from your plan to chase a hot trend, is another risk of investing. Its separate from the risk of losing money or the risk of losing the opportunity to make money. Its psychological risk: the risk that you dont stick with your plan. When you look in the rearview mirror and see charts showing stock market behavior over the long term, it is easy to say time cures risk. But what a long upward line doesnt show is the tremendous impact that a prolonged bear market can have on your emotions. Even a two-year drop doesnt look so badunless you lived in it. Some of you may remember 1973-1974. It was like going down a flight of stairs. Some days the market was flat, and some days it was up a bit, but many more days it was down. After almost two years of this seasick journey, a lot of investors loss faith and trust in stocks. They deserted the market. The S&P 500 was down 37 percent. To make matters worse, inflation was up 22 percent over those two years. That is a 59 percent loss in purchasing power. The price of almost everything, especially gasoline (remember the lines?), was going up while individuals wealth was plummeting. Few people maintained a consistent commitment to their investing plan back then because their courage understandably buckled. Even within single years theres a lot of hidden trauma. The market dropped about 22 percent in one day on October 19, 1987. As many investors panicked out of the market, that October day changed a lot of living standards and a lot of careers on Wall Street. There was a tremendous run-up in the market prior to October 19. Many investors who had no disciplined game planor no tolerance to stand by their game plan started running with the pack of lemmings toward the precipitous cliff. Some of those people who then sold out lost 20 to 25 percent of their money because they acted on this greed-fear double punch. How about September 17, 2001, the first day the New York Stock Exchange opened following the terrorist attacks of September 11? The Dow Jones Industrial Average fell more than 7 percent that day, while the S&P 500 lost nearly 5 percent. Those kinds of nosedives are not easy for the most composed investor to withstand. The long-term figures have a way of smoothing out those painful wrinkles. From 1926 through 2001, large-company stocks returned about 10.8 percent a year on average, according to Ibbotson Associates. So, time historically has ironed out the wrinkles. But you have to stay the course and get through those shorter-term traumas. And its not just traumas on the downside. Its also that pile-on effect mentioned in the prior chapterpeople moving their money from stodgy investments to exciting ones, just in time for those hot items to fall from grace. I remember taking a phone call from a physician client in October 1999. His question was similar to the one I was hearing from many other clients: Vern, do you think we should be in the Amerindo Technology fund? I hear its really moving up and that the manager really knows his stuff when it comes to tech. Maybe he did, but at that time the fund was up about 146 percent. By the end of the year it was up 251 percent. Fearful of chasing hot money, I talked him out of the investment. I was sure he was upset with me for it. But in 2000 the fund lost 65 percent, and in 2001, 51 percent. What that meant was $10,000 grew to $35,100 and ended up being worth $6,019. In the midst of the euphoria, the physician did not think he could bear the risk of missing out. But because he resisted the temptation, he managed to avoid losing money. How can you manage to do the same? While part of the risk calculus you need to make is based on the goals you need to reach, part must be based on how much risk you can take psychologicallyyour risk tolerance. |
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