It's natural to have fears about your nest egg. After all, your savings are central to your quality of life, both now and in the future. On the other hand, your nest egg is too important to let fear influence your investment process—because making decisions based on fear is likely to hurt your investment performance.
Part of the reason for that is because market timing—jumping into and out of investments in an attempt to catch rises and avoid drops—is so hard to do. Consider the average investor’s tendency to underperform the market as a whole according to DALBAR Inc.'s "Quantitative Analysis of Investor Behavior 2013." That study shows the impact of market timing, as well as high fees and asset allocation decisions that may hurt investors—the S&P 500 returned an annualized 8.21% for the 20 years through 2012, while the average investor in U.S. stock mutual funds achieved an annualized return of just 4.25%.
"Investing is stressful, and that stress causes us to make emotional—usually fear-based—decisions during difficult market periods," says Dr. Frank Murtha, the co-founder of MarketPsych, a New York–based behavioral economics consulting firm. "But fear-driven decisions are not designed to meet financial goals, they’re designed to meet emotional ones—namely, to feel in control again.” And it works. But that relief comes at the cost of long-term performance.
Never is the threat to our nest egg more intense than during a period of "market crisis." Whether it's another financial crisis or some other market meltdown, we know that a crisis of some sort will inevitably happen again—we just don't know when. History also suggests that sticking to your plan through those crises can pay off over time. Indeed, tracking more than 8 million investors who participated in their 401(k) for the 10 years from Q1 2003 through Q1 2013 saw their balances nearly quintuple—despite a major market downturn in 2009.
Below are five proactive steps we can take to help prepare us for whatever surprises the market has in store for us.
1. Develop clear goals
Most financial planning advice starts with this step, so you may be tempted to breeze past it. Resist that urge. If you haven't carefully considered your long-term goals, it will be all too easy to abandon them when the market declines.
So dig in here: Think about your goals specifically and in detail—e.g., where you want to live, how you will spend your time. Rather than simply saving "for retirement," develop a specific vision. For example, you might decide that you’re saving to retire at age 67, when you and your spouse will move to Sedona, Arizona, and make three to five trips a year to see your grandchildren. Or you could focus on paying for your kid’s dream college, while taking vacations to Central America. Whatever your specific goals may be, take the time to imagine how you’ll feel when you achieve them. “You need to put yourself in the future, not just as an intellectual exercise but as an emotional one.”
The process of picturing yourself achieving your goal helps move your brain’s focus from the distraction of short-term concerns to long-term goals. It also engages the limbic system, the part of the brain that governs emotion, meaning that you are now emotionally invested in your own long-term goal—something that’s difficult to achieve if you don’t think about it in detail. “We need to remember that simply making money is not the purpose of our investing,” says Murtha. “We’re investing to lead the kind of life we want to lead for emotional reasons.”
2. Use a trusted financial professional
Most financial firms can help you develop a well-conceived, prudent financial plan. Be sure that the professional you choose also is truly interested in your goals. He or she should inquire about them in detail, helping you tap into your limbic system and remain engaged with the emotional consequences of your investment decisions. And your plan should be built around your objectives. “Your professional should make your goals intrinsic to what you’re doing as an investor,” says Murtha. “If your portfolio is up by several percentage points, for example, he or she should put those results in the context of your goals.”
3. Have a written market crisis plan
It’s a given that financial markets can be turbulent, and that turbulence affects the portfolios of individual investors. But that knowledge alone is unlikely to inoculate you against an emotional reaction to a prolonged bear market, similar to the one that followed the financial crisis. “Fear is an emotion that consistently subverts performance,” says Murtha. “But when it turns into panic, that’s when portfolios self-destruct,” he says. “A written crisis plan is essential for most investors—including the most independent, speculative, aggressive trader out there,” says Murtha. “In a crisis, the best way to prevent panic is to feel you’re prepared for it. The more structure and tools you have in place, the better off you’ll be.”
A financial professional can work with you to create a crisis plan that suits your specific circumstances. It might include controls on your investing behavior. For example, you might agree to have a conversation before making any trades when the market has dropped more than 10%, or to enforce a specific waiting period on any trades you’re contemplating in a down market. In the process of developing your crisis plan, your professional might suggest that you write a list of reasons to stay invested for the long term. You can then refer back to this list when prices are falling. “The list reinforces the wisdom of your plan and connects you to a more rational state of mind,” says Murtha.
4. Consider your coping mechanisms
Stress is a corrosive force constantly eroding our ability to make healthy decisions. How we manage that stress is a crucial factor in long-term investing success. During periods of intense market volatility, if we do not have constructive coping strategies for market stress, we often default to destructive ones (e.g., impulsive selling, decision paralysis, complete avoidance or denial). Take the time to flesh out coping strategies that are healthy and productive, and that you’d like to employ in times of volatility.
A financial professional can help with this process. Perhaps he or she will suggest that you take a time out from the market, in which you agree not to pay attention to financial news for a set period of time. Another tactic can be to reread an article on investing that resets the proper focus. Or your advisor might plan to send you a list of previous market downturns and subsequent market performance. “The broad market indexes have been remarkably resilient through some of the worst disasters imaginable,” says Murtha. “Having healthy coping devices available to us ‘in the moment’ is what keeps people from resorting to the self-destructive behaviors that haunt investors long after they’re done.”
These coping mechanisms, and others you identify with your advisor, will be more effective if implemented in concert with a financial plan that is appropriate for your risk tolerance. After all, a plan that exposes you to more risk than you are comfortable with will increase the amount of volatility—and, thus, the amount of stress and fear—you experience. And that will make it more challenging to stay the course. Healthy coping strategies can also be implemented as part of a broader crisis plan.
5. Monitor your plan regularly
Your life changes over time. Your financial plan ought to change with it. At least once a year, consult a financial professional to review your financial plan. During this review you can revisit your goals and the strategies you’ve put in place to meet them, as well as your portfolio’s performance and your crisis plan.
You and your advisor can also discuss the market’s performance over the past year, with an emphasis on how you responded emotionally: Did you make investment decisions motivated by fear? Did you use the coping mechanisms you’d identified ahead of time? Which elements of your crisis plan proved particularly helpful? This information can help you revise both your overall financial plan and your crisis plan so you can work toward your goals more effectively.
You have a great deal of power over the influence that fear and other emotions can have on your investing decisions. You and an advisor can put strategies in place that limit the sway those feelings have over your decisions, freeing you to make better choices—all in the service of achieving your most important goals.