Part 3 of “Financial Follies: Common Retirement-Planning Mistakes and How to Avoid Them,” a recurring series about the best savings “levers” to pull depending on where you are in your career and your life. Read Part 1: The Cost of Waiting a Year and Part 2: Fees Can Eat Away at Your Retirement Savings.
Greed and fear drive the very worst investment decisions. Greed is easy to understand even though we often only recognize it in hindsight. Fear is a more malicious emotion and its detrimental effects on our savings are not fully appreciated.
When the stock market goes down and people lose some of their hard-earned savings, the fear of loss overtakes the emotions of some investors. Studies have shown that investors fear losses twice as much as they appreciate gains. They see the possibility of a $1 loss as only being offset by the equal probability of a $2 gain.
This phenomenon is a major stumbling block in investor psychology. It can lead to a fundamentally bad investment decision: trying to time the market instead of staying invested for the long term.
Once the stock market takes a downturn, some investors become fearful of losing their money and think they have to sell their investments now to protect what they still have. They deeply discount any prospect of a return to previous levels in the near term. They think they can time the market, sit on the sidelines for a while, and return to investing when conditions are better.
Let’s continue to use the scenario that we have followed in the previous articles in this series. In Part 1 we met Brenda who started her career in 1984 at age 30 and saved 10 percent of her salary for her entire 35-year career. Upon reaching age 65 in 2018, she decided to retire feeling pretty confident because her retirement account had grown to $876,306.
Now suppose Brenda had an unusually skittish temperament and lived in fear of losing her hard-earned money. While she knew that the value of stocks goes up and down, she hated the declines.
Brenda devised a plan that she thought would outsmart the market and earn positive investment returns in good years while avoiding the bad years. Any time the market went down for a whole year, she would sell off all her investments, switch to cash, and hold onto it. In two years’ time, once things looked better, she would reinvest her savings and get back to earning the higher market returns.
Over her 35-year career, she was invested totally in cash for six of the 35 years. She missed some good years when she wished she had been invested, but she also stood on the sidelines and missed some horrible years.
So how did her retirement account fare?
Using the exact same contributions from the previous scenario, but trying to time the market, her wealth took a major hit after 35 years. Her final account value was just $711,015, versus $876,306 if she had stayed fully invested. That is 19 percent less in her retirement savings just because she let fear of loss drive her investment decisions.
The moral? Don’t try to time the market. Getting out when it turns down and trying to get back in when it turns up is usually a bad investment strategy. You’re far better off realizing that investor psychology always values losses as twice as bad as gains, and that this can lead to investors making bad timing decisions. That’s why you should always play the long game.