Read any mutual fund prospectus or industry advertisement. Read the text on the bottom of any financial advertisement in magazines and newspaper. Somewhere on the page you're going to find something that discusses the different risks you will encounter in your investments. You'll read about credit risk, interest rate risk, market risk, risk of loss, risk of yadda-yadda risk.
Why is that language there? Partially it's a limit of liability. If you bought mutual fund ABC at $10/share, then panicked and sold the fund when the share price got cut in half, you'd probably be pretty upset with the managers and the advisor whom put you in the fund in the first place. But, because there is some verbiage about every possible risk to your capital in some document that by law you received when you agreed to invest in the fund, your chances of successfully convincing an arbitrator to arbitrate in your favor are diminished.
Is that language important? Well, because my regulators might read this, YES!!!! How important is it when compared to the other risks that aren't mentioned in the documents? Not at all. Let me explain.
The risks you encounter through investing can mostly be reduced, if not eliminated, through proper diversification and asset allocation. For example, if you have 100% of your capital invested in one company's stock and that company goes bankrupt and you lose all your money, then you quickly become familiar with equity risk. If instead, that company only makes up 3% of your capital because you are diversified into many different companies, then you only lose 3%.
In another example, if, during the normal and not-uncommon gyrations of the stock market, you were to become so upset with the depreciation of your investment values that you liquidated everything to cash, surprise! Meet market risk. Language: "Diversification neither ensures nor protects against losses in the value of your holdings."
However, and this is a BIG however, I would argue that the prior two examples have less to do with equity or market risk, and more to do with a much less discussed, disclosed, or understood risk, and that's behavioral risk.
It is a misbehavior to concentrate 100% of your holdings in one company, regardless of the confidence you hold in that company (think Enron). Likewise, it is how you behave during periods of downward volatility that determines whether that loss affects you permanently, because you liquidated everything to cash and therefore have little chance to experience the recovery in the market, or temporarily, because you understand the additional return we demand from investing in volatile markets is a function of that volatility.
Also, consider the risk of running out of money before you meet your maker, or the risk to your family's future if you're not properly insured before catastrophe strikes. Both of those risks are permanent, and neither are disclosed in any prospectus or disclosure language. And both are a result of misbehavior.
To summarize: All permanent risk in investing is behavioral risk. Any and all risks we associate with investing and managing our finances can be drastically reduced through our behaviors.
Your next question, oh wise reader, is sure to be, "So Brett, how do we prevent our behavior from sabotaging our long term goals?" For my full diatribe into investment philosophy, see my post from July 11th. In its essence, consider the following during the next opportunity for bad behavior:
- Keep the faith. Not necessarily religious faith, but it can be. Have faith in mankind's ability to solve mankind's problems. Invest as if you believe and assume the stock market will never go to zero.
- Be patient. You are investing according to your life expectancy, not the news cycle. Take a deep breath, relax, and remember the old truism, "This too shall pass."
- Stay disciplined. If you're financial plan is sound and you're on track to fund your lifestyle, it should assume periods of low and negative returns in your investments. Stick to the plan and you will be fine.
To prevent misbehaviors, consider the following positive behaviors:
- Continue to fund investment accounts. If possible, increase your contributions temporarily during periods of downward fluctuation. Stocks go on sale just like everything else we buy; don't wait until they're back to full price.
- Disregard all news. Keep in mind, the news outlets' job is not to keep you informed, but to keep you tuned in. Their main source of revenue is advertising, which is driven by ratings, which are increased by manipulating your emotions, of which fear is the most powerful. Also take some time and marvel at the fact that they are never held accountable for predicting things that do not come true.
- Call your advisor. If he or she is worth their salt, their job is to give you some perspective into current events, remind you of your long term goals, and guide you through periods of anxiety. My contact info is all over my website. Just sayin'.