Most everyone tells you that in order to make the best retirement investments, you have to ignore your emotions. They trot out fancy charts and graphs to prove their point.
And they’d be right. As investors, we would be far better off if we ignored our emotions. There is only one problem with that idea.
If you’re human, you can’t do it.
Consider the graphic to the right.
It shows that investors earn roughly half what their investments make. Why? Because people react emotionally. We get frightened, so we sell. We get greedy, so we buy.
All this emotional investing costs us a fortune. Wait…didn’t I just contradict myself?
If investing emotionally is so expensive, why am I telling you to embrace your emotions? Have I finally lost my mind as my wife and kids keep suggesting I have? No. That’s not the reason at all.
I suggest that you embrace your emotions when you invest because you simply can’t do otherwise. There is a huge difference between reacting emotionally and using your emotions when you invest.
Know Your Emotions Before You Invest
What I’m saying is that if you consider your emotions before you invest, you’ll be less likely to react emotionally when things get sticky.
Ignoring your emotions is like trying to keep a lid on the top of a boiling pot. Sooner or later, the thing is going to blow. That, in a nutshell, explains the graphic above. I’m going to propose a solution, but first I’d like to play make-believe with you.
For a moment, make believe that you are a financial adviser. Your client, Denise (real person, different name), comes to you with a dilemma. She’s 57 years old and a single woman. She has a grown son but she supports him every now and then. Denise is only a few years away from retirement. She invested her $300,000 for retirement in the market and now it’s become $171,000. Look at the chart below and just imagine how she felt each month as her account value dropped. (Maybe it isn’t that hard for you to imagine…)
Denise comes to you for advice. She tells you that she can’t tolerate any more market losses and has started checking online savings accounts. At the same time, she tells you that she’s afraid of pulling all her money out and missing the market recovery.
You have three choices:
a. Tell her to ignore the market. You’ve got the graphs to prove why. Just increase the Zoloft.
b. Move everything to the online savings accounts – just like her friend Tom told her to do.
c. Compromise by putting half the money in short-term bonds and keeping the other half in the market.
What would you tell her to do? Why? How would you explain it to her? Do you have a fourth option for Denise? You may already know what my opinion is, but I’ll share it with you anyway next Tuesday.
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{ 9 comments… read them below or add one }
Thanks again for another great post. I’d have to say stick it out. Putting half away won’tmake her feel much better if here $171,000 becomes $120,000. She probably won’t be thinking about how she’s lucky and that it could have been worse.
On another note, I saw that American Express has savings accounts at 1.85% APY. Is this some sort of secret the world has been missing? Isn’t this clearly superior to the 1.30% ING gives? What am I missing here?
Daniel,
I’m going to defer my response to your well thought out comment.
On AMEX…..I think if you have enough money .5% can certainly make a difference. But you have to see if the effort is worth the payoff….right?
Absolutely. For my personal situation, it doesn’t really make much sense, other than feeling good about an extra $20-$30 a year. Maybe in a few years when I have more in savings, but I like ING and now is not the right time to change.
Still, how is it that sites like this don’t list them? They seem to be flying under the radar somehow, and I haven’t read anything about them on any personal finance blogs. I’m just a little confused, that’s all.
Maybe it’s a payola deal.. I don’t know if companies have to pay in order to be listed or what.
Neal,
At this point, I would have to do something the lines of A & C. I would look to her other assets, does she have a whole life policy that the cash can be used until the market recovers? Does she have an annuities that can provide for the years until the market recovers?
Those products which are normally hated upon on personal finance blogs – could save her.
Kind off topic! but I usually am lol
Evan, I have to say I was asking the same questions. An annuity with downside protection might be just what she needs. It would give her market participation with guarantees since she is probably hoping to retire in 10 years or so. Yes there would be extra fees for this. She also just might be willing to pay a little extra for her peace of mind.
Evolution,
Everyone (most PF Bloggers – not Neal) Rip apart the annuities because of the fees, but those fees might have guaranteed that this client had a lot more than her $120K
My 4th option for Denise would be to educate her. Denise’s current risk tolerance is fairly small. Show her a simulation on how far she would likely get with $171,000 in cash including inflation. Hopefully, this will persuade her not to withdraw the money.
Option C is fairly close to where she should have been in the first place so close to retirement. Although, I would have invested in long-term instead of short-term bonds.
You are all putting together great ideas…I’m going to do an entire post on this Tuesday.
Keep the ideas flowing!