Have you ever been in a situation where you spot a news item that you know will make the market drop?
At that point, the temptation is to act on this feeling and make the appropriate changes to your investments so that you’ll benefit from the outcome. This overconfidence creates an emotional framework surrounding this prediction that makes it seem so certain, but there’s a second decision attached, which most investors don’t consider.
Moving to All Cash
The Prospect Theory states that people fear losing more than they value winning. There was a great example of this emotional tug-of-war in a recent article in Money Magazine, called, “My brilliant sell-everything trade.” In this situation, the writer, a regular reporter on mutual funds and investing information, made the decision just before the debt-ceiling decision last summer to move all of his 401k investments to cash based on his fear of a pending market drop. Throughout the article the writer does a nice job dissecting his decision-making and the difficulties he’s experienced since he made that move.
The Second Decision
What most people don’t realize is that when making a fear-driven decision to move money out of the stock market, you are also adding another likely tougher decision of when to move money back in to stocks. Inevitably, to make this move so that it is most beneficial to you, you would need to sell stock investments before things looked bad (selling high) and then shift money back in to stocks when things looked even worse (buying low). This is contrary to the “let’s wait until things look better,” comment we hear most often in these situations.
Making drastic emotional decisions during market extremes can be dangerous to your long-term returns. Instead stick with a diversified investment strategy that is designed with your risk preferences in mind. Market shocks will continue to happen, but having the awareness to separate your emotional response from the rational response will benefit you over time.
