The Behaviorist: Managing Risk With A Plan

July 19, 2011

A good investment plan is the best protection against buying high and selling low.

In late September 1987, I received calls from two clients who were at opposite ends of the risk spectrum. The first call was from my most aggressive client, a wealthy speculator who never worried much about risk. He quickly got to the point, asking, “Aren’t we holding too much cash?”

Kent GrealishThis was back in the days when I believed I could time the market. So, when I observed the market bump up against the top of a trading range at the beginning of the year, I recommended that clients raise cash. Unfortunately for me, from the start of the year, the market moved steadily higher for the next nine months.

So I repeated to my client the reasons for my caution at the beginning of the year (market price/earnings ratio, book value, dividend yield, etc.) and how there was even greater reason for concern now that the market was a good 30 percent higher. My client listened patiently and finally said: “OK … for now.” Clearly, my relationship with him was on borrowed time.

Within a day or two, I received a similar call from my most risk-averse client, who had been widowed a few years earlier. Her husband had made all of the investment decisions and she had been justifiably concerned about managing so much money.

When we first met, she told me how her most important objective was to protect the investment capital so she could pass it on to her children. She too asked, “Aren’t we holding too much cash?”

Once again I went over the reasons for my previous recommendation and how I felt they were still valid. Then I reminded her of her concerns about losing money. At the end of the conversation, she agreed to maintain the cash reserves, but I could tell that she wasn’t completely satisfied.

The October ’87 crash came a few weeks later and the stock market dropped 22 percent in a single day, leaving it 30 percent below where it had closed the previous month. The next day, I got calls from both clients and each asked the same question: “Aren’t we holding too much … stock?”

This dramatic shift in attitude may seem strange at first, but in my experience, it’s very normal. Investors’ perception of risk can quickly change depending on the circumstances, which serves to underscore the danger of ad hoc decision-making.

The best protection against overreacting to sudden changes in the market is a written investment plan customized to your objectives and risk tolerance and that is anchored by a comprehensive investment policy statement. A well-constructed investment plan can insulate you from your own worst impulses and will serve as a reality check during volatile markets. Fortunately, both of my clients had resisted the very human urge to buy high and sell low.

However, the memory of how they had felt both before and after the crash of 1987 would fade over time. They neither remembered with any clarity how much they wanted to own more stocks beforehand and how much they were dying to get out of the market after it crashed. Again, such reactions are perfectly normal, in my experience.

In the end, we have to accept the fact that human nature will periodically skew our perception of investment risk and tempt us to act on feelings rather than facts. Admittedly, developing and following a solid investment plan may not be easy, but making investment decisions based on feelings is definitely hazardous to your wealth.


Kent Grealish is a financial advisor with San Bruno, Calif.-based Quacera Capital Management LLC. Grealish, an accredited investment fiduciary® (AIF®) and a certified financial plannerTM (CFP®), provides services on an hourly, fee-only basis.

 

 

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