Stock market investors have made some big gains in the past year, but keeping those big gains in perspective is a critical part of avoiding one of the major psychological market traps.
Generating big investing returns in bull markets doesn’t make an investor infallible. In fact, it doesn’t even make him or her above average.
It’s easy to look at a portfolio full of big returns and think you’ve got Wall Street all figured out. But the reality is that almost everyone who bought stocks in the past year is looking at the same thing. Twenty-seven of the 30 Dow Jones industrial average stocks have positive returns in the past year, and 23 of the 30 have double-digit gains.
Incredibly, half of those 30 stocks have gains of at least 26 percent, and five have gains of at least 50 percent.
The danger comes in looking at a portfolio of stocks, seeing 30 percent-plus gains over a one-year stretch and concluding that you are an investing genius who doesn’t need to follow the investing rules that help protect everyone else.
The higher those returns are, the more dangerous the psychological fallout can be. Shares of Paypal Holdings (Nasdaq: PYPL), Square (SQ) and Nvidia Corp. (NVDA) have all more than doubled in price the past year. The Bitcoin Investment Trust (GBTC) is up more than 1,400 percent in that time. Investors who singled out these particular stocks or other similar big winners are likely feeling emboldened just when they should be feeling particularly vulnerable.
“We had an ideal environment last year … so for investors to pile into an asset that many do not understand is indicative of that environment,” Chubb says. “That behavior should have all investors concerned, as it implies complacency.”
Chubb says positive fundamental indicators, such as global economic growth and corporate earnings, have played a role in investors aggressive behavior as well.
Ironically, many investors feel the urge to abandon protective strategies at the worst possible time. When you’re picking winners left and right, diversifying a portfolio, investing in blue-chip stocks, avoiding excess leverage and keeping a certain amount of cash on hand may start to seem like unnecessary precautions. Periods when the market is on fire and profits are coming quickly and easily can be some of the most difficult times to maintain long-term investing discipline.
Owen Murray, director of investments for Horizon Advisors, says investors must fight the urge to abandon their long-term strategy and go chasing after high-flying stocks and cryptocurrencies when the market is at its hottest.
“Anytime you have a significant upswing in the market, the potential for low or negative returns in the near term increases,” he says. “For a long-term investor, short-term swings in the market shouldn’t have a meaningful impact on long-term strategy.”
The phenomenon of investors piling into the hottest stocks and cryptocurrencies has become so prevalent in recent months that it has earned its own nickname – FOMO, or “fear of missing out.” FOMO traders have been pouring money into whichever assets have been generating the highest returns. They don’t want to feel like they are missing out on the action.
Mike Loewengart, vice president of investment strategy at E-Trade, says instead of buying FOMO stocks, long-term investors should dial back their exposure to top-performing stocks. When certain stocks and market sectors get particularly hot, a phenomenon known as “drift” can subtly change the composition of a portfolio and expose investors to more risk than they realize.
“When certain assets perform vastly better than others, it can alter the original weight of assets in a portfolio,” Loewengart says.
As an extreme example, a portfolio that was only 2 percent allocated to bitcoin at the beginning of 2017 may have ended the year with a 20 percent (or higher) bitcoin allocation, which is much more exposure to the risky cryptocurrency market than originally intended. Rebalancing portfolios too much can lead to unintended negative tax consequences and higher commission fees, but Loewengart says rebalancing two or three times a year is typically plenty to keep drift at bay.
“Periodic reviews and rebalancing – as in a couple of times a year – is an important method to keep original allocations in check,” he says.
Bull markets don’t last forever, and that feeling of invincibility that many investors are feeling these days won’t either. It’s great to be proud of smart investing decisions that end up paying off. But having a couple of good years in the middle of one of the strongest bull markets in history is…
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