All too often, we as financial advisors are in the awkward position of telling clients things that they may not really want to hear. Frequently, these situations involve discussions about focusing on goals, looking past negative events and practicing patience. We believe that many of these talks arise out of the fact that as a culture, we Americans have been trained to view action and activity as positive, inactivity as a sign of weakness, and control as desirable, even if it is illusory.

In this piece, we’ll take a look at some of the misconceptions that are common in the investment arena. Many of these are taken from the study of behavioral finance and psychology. Contrary to the beliefs of some, investing is heavily influenced by human behavior and psychology. It can be very useful therefore, to have an understanding of some of those issues.

It’s not uncommon for us in the industry to hear from clients who have a desire to “change things around”, to take action in an effort to exert some control over their portfolios, in hopes of accelerating performance. Other investors take action to move in and out of markets entirely, usually in volatile times, hoping to avoid negative market volatility. Given Americans’ proclivity for control, it’s understandable, but too frequently misguided. However, it rarely, if ever, pays to allow personal emotions to drive investment actions.

We know that moving in and out of markets in an effort to avoid downturns and capture upswings (a.k.a. market timing) has shown itself time and time again to be a recipe for failure. Research has shown over and over that in periods of market corrections or bear markets, many individual investors have a propensity to exit markets entirely, only to miss the subsequent rebounds, and therefore sacrifice overall returns¹.

This was clearly in evidence in the Financial Crisis of 2007-2008, where many investors headed for the sidelines and stayed out of markets, some for many years, after the March 2009 recovery began. In his study entitled Individual Investors and the Financial Crisis: How Perceptions Change, Drive Behavior and Impact Performance, Pennings points out that during the Financial Crisis, when investor risk perceptions and return expectations showed significant fluctuation, more successful investors traded less, took less risk, and had lower sell-buy ratios. Other similar studies were conducted, and as a group exposed that large numbers of individual investors exited the markets in 2008 and into early 2009, not to return for several years after the market recovery had occurred. The impulse to take action and exert control (perhaps based on fear), significantly damaged returns for many investors.

In fact, it is clearly evident that any long-term bet against modern U.S. equity markets has not been particularly rewarding. Since the early 1950’s, the S&P 500 has experienced two extended periods of stagnation: 1973 – 1982 and 2001 -2012. Both periods were followed by extended bull markets that rewarded patient investors.

Behavioral finance offers many insights into the characteristics of investors in general, and those of successful investors. Other academic research has looked to identify the factors that both successful investors, and investments themselves carry with them. We can all understand and often relate to the traits that successful investors possess. As for the investments themselves, it is not as intuitive or simple.

So, while it is known that market timing is generally imprudent, this is but one of several forgotten truths and open secrets about the markets that we witness.

Trading based on current news headlines is usually counter-productive

Most people have heard the comment that markets are discounting mechanisms, but many may not understand the specific meaning. Essentially, this means that at any point in time, markets tend to “discount” (or price in) expectations for future events (most importantly, future corporate profits).

In this age of instantaneous transmission of news and data, markets tend to discount current events almost instantaneously. The effect of news on markets tends to be in the context of what it means for the future. For many investors, that time horizon is 18 months or longer. Thus, it is said that at any point in time, markets tend to reflect present and likely future events.

Additionally, markets don’t typically reflect the current state of the economy. Projections of corporate profits (the single greatest driver of asset prices in the long term) are constantly being reviewed, remodeled and analyzed for risk factors with an eye toward future outcomes. Valuations are measured on a variety of metrics. Asset flows are tracked. These are just a few of the things that go into prudent investment decision making. So, trading headlines amounts to dealing in old news that the market has already discounted.

Following research rather than rumors is fundamental

In bygone days before instant data and communications, investors routinely made investment decisions based on endorsements and rumors. In the past, communications moved more slowly, information was less available and asset prices were less volatile. In today’s markets, basing investments on such things amounts to little more than a hope that the asset will provide a return. The volume of information that is essential to making intelligent investment decisions is far greater, and requires much more care than in the past in order to hold the moniker of a “prudent investment.”

Understanding the drivers of asset prices and how to own them is the essence of investing

Nobody would expect an emergency room doctor to be fluent in the factors that drive asset prices. By the same token, I would (hopefully) never be called upon to care for a severely injured patient. We all have our areas of expertise. That said, I believe that many people think that investing is a lot simpler than it looks. For most of us, our financial security and independence is a serious issue. Accordingly, the principals of investing should be fully understood, lest harm be done.

This is not intended to be a lesson on securities analysis. It should be known, however, that at the most straightforward level, earnings (or corporate profits) and /or cash flows are among the most important drivers of asset prices over time. It can further be argued that over the long term (5-7 years typically) excess equity returns are commonly generated by those companies that have the ability to increase profitability and/or cash flow at a rate above that of the overall market (or average company). The skill and strength of corporate management is closely related to this ability, and can also be considered a primary driver of stock price.

You may be familiar with the proclamation that “our expected holding time for an investment is forever.” This is an often heard phrase in the asset management industry, and it expresses an important investment principal; that if one invests in a company, or group of companies, with superior managements that provide a distinct possibility of above-average profitability or growth of cash flows, and monitors those companies closely over time, then trading in and out of those stocks due to interim volatility is needless. This is the essence of investing. Trading in and out of securities is speculating.

Trading too much and/or too quickly is merely speculating, not investing

Speculative trading involves constant trading into and out of positions. Generally, these trading decisions are based on reasons having little to do with the factors that affect share prices in the intermediate to long term, where opportunities for excess returns can be more readily identifiable.

Asset allocation accounts for the dominant share of portfolio performance

Another axiom, or forgotten truth of investing is that the dominant factor in the performance of the individual investor’s portfolio is the asset allocation. The asset allocation decision should be determined by the investor’s goals, risk tolerance, time horizon. As blasé as this sounds, the allocation is far more important to performance attribution for individual investors than the more spicy topics of security selection, market timing, trading strategies, economics, political headlines, etc. Most strategists acknowledge that asset allocation typically accounts for over 90% of a portfolio’s long term returns.

Identifying one’s goals, risk tolerance and time horizons should be a process that guides the portfolio through time, and is not affected by market events, headlines or emotions. Maintaining portfolio progress is far simpler when the long-term goals and horizons are kept in focus, and short-term impulses are controlled.

Buy low and sell high

The old notion that “the time to buy is when there’s blood in the streets” may be somewhat excessive, but it does illustrate a point. Overreacting to negative events while overlooking present opportunities hinders progress. Time and time again, individual investors sell after a market correction to “reduce risk” when the risk was already in their portfolios prior to the correction. The time to be aggressive is when prices are low, not high. The most attractive opportunities may often present in the worst times.

Sometimes good news is bad news, and bad news is good news

How news affects the markets, oftentimes creating the opposite result of what one might expect, seems to be a dark mystery to many individual investors. When a market rallies on the back of some bad economic release, investors wonder why. Generally, this would be a sign that the negative news was either already priced into the market or that the news wasn’t as negative as expected. Another view might be that negative economic news may result in some policy change, such a monetary policy easing to stimulate a recovery.

Attempting to trade political events rarely, if ever, works

The markets do not typically trade on political headlines. Politics generate emotions that can mislead.

Many individual investors waste opportunities “waiting for things to look better”

As mentioned above, one of the old axioms of investing is that “the time to buy is when there’s blood in the streets.” The inverse of that is something we see too often, and that is investors, scared by negative volatility pledge to wait until things look better. Unfortunately, by the time they look better, the most attractive investment opportunities may have passed them by.

This past year or so is a lesson in this idea. In the period from late March to early September 2020, when the economy was going through one of its most challenging stretches in a lifetime, and things looked incredibly bleak, the stock market was rallying strongly. In that period, the S&P 500 was up over 50% and the Barclay’s Aggregate Bond Index was up over 5.75%. On the contrary, over the period of the second quarter 2021, when we in the U.S. are arguably experiencing a peak economic growth rate, most classes of securities have shown modest returns.

Fear of volatility is the curse of many the novice investor

Suspend disbelief for a moment and consider the fact that volatility has a purpose. Volatility is, in part, markets adjusting themselves to reality. At times, markets can get ahead of themselves, with the price of securities becoming detached from fundamentals by over-speculation. At other times, rallies can occur as markets “catch up” to better than previously projected outlooks. The same holds true for individual securities. Insightful investors use volatility to try to identify attractive entry and/or exit points, or benefit from it through the “dollar cost averaging” process.

Over the history of markets, corrections have occurred fairly regularly, and are typically representative of a normalizing of security prices around a historical trend line, thus the name “correction.” Rather than fear volatility, learning to recognize when it presents opportunity is a much more functional approach for the long-term investor. While there is almost always a lot of “noise” around corrections as they occur, using some of the other ideas presented here may help to separate those things that are important and useful from those that are not.

Chasing momentum is not an investment strategy

The two dominant styles of investing are value and growth. The value style involves identifying undervalued assets in the marketplace that represent a meaningful bargain and possibly provide a meaningful margin of safety. Some value proponents argue that the leading factor in successful investment outcome over time is valuation at purchase. The growth style involves identifying opportunities with companies that are growing profitability at a sustainable above-average rate. Frequently these are companies that are constantly introducing new products and opening new markets for their services.

Then there is momentum. Momentum is a form of speculation, not investing.

The momentum style can be thought of as an effort to identify stocks that possess increasing relative strength vs. the overall market, and speculating on a continued rise. Unfortunately, too many investors ignore the technical relative strength indicators, and simply jump onto stocks that they see advancing at some point in time. To be sure, this form of speculation can yield attractive short-term profits. Too frequently however, investors fail to recognize a deterioration of relative strength factors, and as seen with some of the stocks in the recent news these situations can deteriorate more quickly than they went up. Like many forms of speculation, the momentum strategy could be likened to “trying to catch lightening in a bottle”.

With all that said, things do change, and a certain amount of weeding of the garden is sometimes needed. A certain amount of portfolio turnover can be productive. We view portfolio turnover in the context of the asset class and market conditions. But an excessive amount of turnover is a red flag, indicating a possible lack of conviction on the part of the manager, or other less-productive factors. We feel strongly that turnover for the sake of activity and the illusion of control are ill-advised.

Investing is like most pursuits in life. To become skilled takes knowledge, practice and mastery of the fundamentals. We at Atlas strive to maintain focus on those practices that have shown to be successful over time, and to ignore the “white noise” that overwhelms us all at times. Maintaining perspective in tough times is perhaps the most difficult thing for many investors. By keeping our eye on the horizon, with a solid knowledge of how current events may present opportunities, we strive to make the most of them for our valued clients.

As always, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor to discuss your specific situation with you.

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[1] Individual Investors and the Financial Crisis: How Perceptions Change, Drive Behavior and Impact Performance. Joost M.E. Pennings, January 2011.