You’ll 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 it’s six months later and you’re 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 capitalism’s integrity appeared to have broken down and the markets fell further.
At a time like this, the risk of losing money has materialized—you have far less than what you started with. Money that took you months or years to earn has evaporated. It’s 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 you’re not in the stock market today. But as your mutual fund statements turn a deep red, you’re 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. It’s separate from the risk of losing money or the risk of losing the opportunity to make money. It’s psychological risk: the risk that you don’t 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 doesn’t show is the tremendous impact that a prolonged bear market can have on your emotions.
Even a two-year drop doesn’t look so bad—unless 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 there’s 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 plan—or 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 it’s not just traumas on the downside. It’s also that pile-on effect mentioned in the prior chapter—people 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 it’s 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 psychologically—your risk tolerance.
Read More : Risk Tolerance: The Risk That You Can’t Handle the Risk
