Creating a financial plan is the first step toward building a successful Advisor/Client relationship – mapping the investment strategy and other details that establish a high probability of success. However, even a solid financial plan can be easily derailed by behavioral errors. Advisors can add value by helping steer clients away from committing such behavioral errors. This post will discuss recent real-life examples where behavioral errors may have been easy to commit.
Reacting to Portfolio Drawdowns
When a portfolio is in a drawdown, the reasons to sell and abandon your long-term plan often seem compelling. On April 2, 2020, the U.S. Bureau of Labor Statistics released its monthly non-farm payroll report, which detailed the unemployment rate, how many jobs were created/lost, and other labor market statistics. The numbers were staggering – over 7 million jobs lost and an unemployment rate of 14.7%. The U.S. labor market was in the worst shape since the Great Depression, and it would have been easy to believe that the equity markets had much further to fall.
However, though it was impossible to know at the time, equity markets had bottomed in the previous week. Had a client (or even an advisor) reacted to the shocking unemployment data and sold their equity exposure hoping to sidestep further downside, they would have missed the extraordinary rally that followed.
Performance Chasing
Performance chasing is the opposite of panicking in a drawdown. Whether it be the SPAC (special purpose acquisition company) craze of early 2021, microcap growth stocks, cryptocurrencies, or just a rapidly appreciating equity market – it is easy for investors to see others “getting rich quick” and wanting to participate. This fear of missing out may lead an investor to abandon their financial plan and take more risk which, if done at the wrong time, could have a devastating impact on portfolio returns.
Throughout 2020, and accelerating into February 2021, certain pockets of the market were on fire. For example, the Goldman Sachs Non-Profitable Tech Index had 5x’ed over the course of a year. SPACs were doubling and tripling, sometimes before a deal was even announced.
While it seemed like these parts of the market might never pull back, they generally peaked in mid-to-late February, and many are now down more than 50% from their peak. Performance chasing investors who had grown tired of not participating in February and decided to chase after these hot areas of the market are now sitting on substantial drawdowns. Thus, their performance chasing derailed their well-crafted financial plan.
The Bottom Line
Though not an exhaustive list, the foregoing examples demonstrate how behavioral errors can lead an investor to deviate from their financial plan to the detriment of their portfolio returns. While it is crucial to avoid these costly errors, it is important to note that this does not mean the financial plan should never change – but investors should avoid making emotionally driven changes not dictated by a change in circumstances.