When Investing, Most of Us Set Ourselves Up for Losses, It's Time to Stop

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Published April 28, 2014

| FOXBusiness

Erik Davidson, chief investment officer at Wells Fargo Private Bank, is frustrated.

To him, the world today is full of opportunities for making money. Instead of taking advantage, he says clients are hunkered down, stuffing their portfolios full of “safe” investments like bonds and cash. The problem is, as they stretch for a higher return, investors are moving into lower-quality types of bonds or those with longer maturities. In both cases, they are taking on more risk than they realize.

While the Federal Reserve has indicated it will not be raising short-term interest rates any time soon, the Fed does not control long-term rates. “By reaching for yield out the maturity curve, investors are putting themselves at greater risk for price declines if interest rates move higher,” warns Davidson. “The catalyst,” he says, “will be a return to ‘normal.’”  

He says to keep an eye on Gross Domestic Product (GDP) and inflation numbers: As these economic measures begin to approach their historical averages, long-term interest rates will rise. Easing geopolitical tensions will also send the long end of the yield curve higher. As these rates rise, long-term bonds will lose value.

Perhaps you think that cash is a safe place to sit things out. Talk to your grandmother. Every senior citizen can tell you how their purchasing power has declined thanks to the pittance they’re earning on CDs and money market funds. Even below-average inflation has made these accounts a losing proposition.

Why do we do this to ourselves? There are dozens upon dozens of research papers, experiments and books written on the topic of behavioral finance that label this particular mindset “loss aversion.” A fancy term for “I don’t want to lose any of my money.” The bottom line is that we are our own worst enemy when it comes to making financial decisions. You might be the coolest negotiator on the planet, and have the ability to perform mathematical calculations to the fourth decimal point in your head, but when it comes to your own investments, your emotions wreak havoc with the returns you earn. It’s the reason even portfolio managers should have a financial advisor: Most of us need someone who is emotionally detached from “our” money to nudge us in the right direction and stop us from making stupid decisions.

A survey of Wells Fargo’s private banking clients illustrates that having a lot more money than the average person doesn’t mean you aren’t susceptible to making the same mistakes as the rest of us. 

For instance, in the wake of the bear market caused by the 2008-2009 financial crisis, 28% of those responding said they had made “major” changes to their portfolio. That number rose to 41% among those with the largest amount of assets ($3 million and above). And what did these folks do with their money? Nearly half sold stocks. Where did the proceeds go? Primarily into money market accounts and bonds. 

In other words, they sold when stock prices had plummeted and re-deployed the proceeds in investments that had gone up in price (mainly due to increased demand) or left it to wallow in an investment that--for years--has been guaranteed to lose money on an inflation-adjusted basis. 

Translation: They bought investments that had gone up in price with money they got from selling other investments that had gone down. Just the opposite of the mantra to “Buy low, sell high.”  

And, all of these wealthy individuals had a financial advisor who was presumably urging them to--at the very least--do nothing, to ride out the short-term turmoil and uncertainty. But their emotions got the best of them. According to one study, the emotional/mental “pain” of losing money is twice as intense as the pleasure one gets from a gain. Fear wins.

Remember the folks who claimed they moved everything to cash in their 401(k)s back in 2008? They missed the subsequent recovery in the markets that would have enabled them to reap huge gains and more than make up what they had “lost.”

Davidson is not a Pollyana. He acknowledges there are troubling unknowns on the horizon.

For starters, there’s the standoff in the Ukraine, which happens to pit the world’s two largest nuclear powers. He acknowledges that a reversion back to the Cold War days of the 1950s and 1960s would be “very frightening.” But Davidson points out that this is highly unlikely. “It’s not logical. It’s a different world [today]. Russian is not the same as the Soviet Union. It is struggling itself economically. Its population is in decline and aging. There’s free flow of information and capital.” 

Moreover, Russia is highly dependent on the price of oil and natural gas, its main exports. The markets, made up of investors around the world, have made their opinion of Russia's President Vladimir Putin aggression abundantly clear by sending both the ruble and the country's stock market down sharply. “That didn’t happen in the Cold War,” says Davidson.

The point is, in today’s financially-interconnected world, there will always be something to worry about. Some reason not to invest. A natural disaster. The bursting of the technology bubble. Governments overthrown in the Middle East. Real estate value plummet. Greece can’t afford its debt payments. Recalling this country’s record-breaking deficit, Davidson points out that, “a year ago we weren’t worried about Crimea, but about a much more scary place:Washington, D.C.”

He maintains that “despite things that are worrisome, there are lots of exciting things going on in the markets globally.” For instance, he points out that there are 7 billion people in the world today, and each one is a potential consumer. Two billion of them are considered “middle class.” This number is expected to double by 2025.

Doomsayers will wring their hands and worry how our planet can support such a growing population. Others see a massive opportunity. As individuals move up into middle class status, both their diet and lifestyle change. They can afford tangible things they never imagined- from cell phones to toothbrushes to washing machines.

Moreover, the demographics of the emerging global middle class are extremely favorable compared to the populations of older, established economies: This emerging middle class has a median age is 27, a critical age for household formation. This is lower to a median age of 34 in the United States and 44 in Japan and Germany.

"Investment capital is flowing across borders,” says Davidson. Companies that are headquartered in developed nations are rapidly moving in to fill the wants and needs of this new middle class- and finding a new source of profits. “There’s an outbreak of capitalism all over the word!”

In fact, when it seems like there’s nothing to worry about (tech stock prices can only go up and interest rates will always be low) that’s exactly when we should be worried, says Davidson.

URL

http://www.foxbusiness.com/personal-finance/2014/04/28/when-investing-most-us-set-ourselves-up-for-losses-it-time-to-stop/