An investor's guide: Expect the unexpected

In Morgan Housel's best-selling personal finance book, "The Psychology of Money," he warns investors against the notion that the future will be exactly like the past.

Housel writes, "History is mostly the study of surprising events. But it is often used by investors and economists as an unassailable guide to the future."

As an investor, it's common to look to past investment history when designing your investment portfolio, though past returns do not necessarily indicate future results. Therefore, it is often better to focus on general takeaways and use fundamentals to guide future decision-making when looking to the past.

There are many takeaways that investors can glean from the past and use it as a roadmap to the future.

First, the stock market can fluctuate dramatically in the short run.

When it comes to investing in the stock market, investors are wise to understand that it is very common for the market to fluctuate up and down dramatically.

Using the S&P 500 as a guide, we can see that a market correction—a fall of 10% or more from the previous high—occurs on average every 1.87 years. Since the beginning of 1950, there have been 38 such corrections.

Alternatively, when investors zoom out and view returns from the S&P 500's inception in 1926 to today, it's returned roughly 10% per year on average. Again, this is an excellent indicator of the rewards investors receive over the long run, though the ride is anything but smooth and steady.

The time between recessions has changed over the last 150 years.

In his book, Housel shows that the average time between recessions has changed dramatically since the mid-1800s.

"The average time between recessions has grown from about two years in the late 1800s to five years in the early 20th century to eight years over the last half-century," he writes.

This point seems less like a prediction of when the next recession will occur and more of a forecast that we can count on the timing to keep changing. Housel writes that there are many theories as to why the time between recessions is increasing, with economists highlighting everything from the current monetary policy to the dominance of the service sector.

That said, one thing is sure, "things have clearly changed," Housel writes.

Investors are often their own worst enemy.

If one thing remains steady throughout time, it's the gap between what investments return and what an investor receives. This is a term known as the Behavior Gap, coined by financial planner, Carl Richards, to describe poor financial behavior's impact on an investor's portfolio.

Put simply, investors tend to underperform the investments they have. This is due, in large, to the emotionally charged investment decisions investors make. Typically, investors become fearful when stock prices are down, often causing them to sell at the bottom. In contrast, when the market is up and prices are high, investors experience greed and continually invest more money at a higher price per share. In addition, many investors attempt to time the market, hopping in and out at various times to try and avoid a crash or catch a significant upswing.

Exact estimates range, but on average, investors underperform the stock market somewhere between 1 and 2% per year, which can have a devastating impact on their overall portfolio value over long periods.

Here's an example to help understand the impact of the behavior gap.

Let's imagine that over 30 years, you invested $1,000 per month and earned a 10% annual return—capturing the total investment return of the market. You are a savvy investor who has decided to stay the course and not let your emotions drive the boat. At the end of the 30 years, you would have a portfolio value of $2.28 million.

Contrast that with the behavior gap example where you jump in and out of the market and constantly change your portfolio to chase the best returns. In this example, you invest the same amount over the same period but earn 9% instead of 10%, a 1% reduction due to poor financial decision-making. Unfortunately, in the end, you would wind up with $1.84 million—an overall loss of almost $440k!

Now let's imagine that the results were even worse, causing you to underperform the market by 2% per year over the same period; you would end up with just 1.5 million—a loss of $750k due to poor investment decisions.

Sam Watkins, CIO, CFP® TrueNorth Wealth

TrueNorth Wealth is a zero commission, fee-only, financial planning firm. TrueNorth Wealth specializes in high-net-worth individuals. We offer academically sound financial planning, and we educate each client on what our investment philosophy is, and why. We take an active role in helping each client examine their tax bill each year and creating meaningful strategy to manage that tax liability. If you are looking for an exceptional advisor, call TrueNorth Wealth for a no-cost consultation, today! 801-274-1820

So how can you prepare for the unexpected while limiting the behavior gap?

1. Design wiggle room in your financial plan.

When setting up a financial plan, building in some 'wiggle room' or extra margin of error is key to success over the long term. Often, wiggle room looks like having 6 to 12 months of expenses saved in a rainy-day fund. Having that buffer allows investors to withstand financial hardships without having to sell off their investments. For many, this is the safety net standing between them and potential bankruptcy due to an unexpected job loss, business failure, or divorce.

In addition to ample cash reserves, it is essential to have some space between your income and your expenses. The more significant the difference between what you earn and spend, the more flexibility you have when things go wrong. Unfortunately, many tend to spend as much or more than they make, constantly inflating their lifestyle as earnings go up.

2. Focus on general takeaways from history.

Investors would be wise to focus on general takeaways and fundamentals rather than specific dogma when looking to the past.

Housel highlights this point in his book. "The further back in history you look, the more general your takeaways should be. General things like people's relationship to greed and fear, how they behave under stress, and how they respond to incentives tend to be stable in time. The history of money is useful for that kind of stuff," he writes.

3. Avoid extreme ends of planning where many things need to go right for you to succeed.

Lastly, avoid extremes in financial planning. The more you need things to go right for your plan to succeed, the more fragile your financial plan is. In contrast, focus on building a financial plan where many things can go wrong, and your plan will still be successful.

One of the common ways this shows up in financial planning is through diversification. Simply put, investors are wise to diversify their investments, spreading the risk across many different companies and asset classes. Diversification means that even if many of your investments fail or underperform, your plan can still succeed because of exposure to the few investments that produced significant returns.

TrueNorth Wealth is here to help.

If you're interested in working with a trusted Financial Advisor that can help you create a financial plan that secures your future, we're here to help.

At TrueNorth Wealth, one of Salt Lake City's leading wealth management firms, we focus on helping our clients build long-term wealth while maximizing the enjoyment they receive from their money. We do this by pairing our clients with a dedicated CFP® professional backed by an incredible team. We understand that it can be challenging to maintain a long-term investment mindset, which is why we help our clients understand the bigger picture and the impact of each financial decision.

For our team at TrueNorth, it's about so much more than money. It's about serving families all across Utah and helping them achieve freedom and flexibility in their lives. To learn more or schedule a no-cost consultation, visit our website at TrueNorth Wealth or call (801) 316-1875.

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