Keep Emotion Out of Your Portfolio

Last week was the first down week for the markets after almost nine straight weeks of gains, which is pretty remarkable considering it was just a few months ago that readers were asking me whether stocks would ever go up. The rally resumed this week, with big gains Monday. From their lows on March 9, stocks have registered some of their steepest gains since the 1930s, which takes us back to the Depression for comparisons.

So why aren't more investors celebrating?

True, stocks are still down 40% from their highs of 2007 so most people don't feel nearly as wealthy as they did back then, even after the historic rally. But I sense that's not the reason that so many investors are feeling so cranky. It's because they missed it.

If fear and greed are the defining emotions of investing, then there's nothing like a missed opportunity to bring out the greed. Many usually sober people bought into the doomsday scenarios prevalent in January and February. Not only were they unwilling to bet on stocks recovering any time soon, they actually bet against the market — piling into safe haven U.S. Treasurys, moving heavily into cash, and even in extreme cases shorting the market. And then they sat back to wait for their actions to be vindicated.

So far, they have waited in vain. As stocks have soared, those super-safe Treasurys have slumped, dropping in value by about 20% since the first of the year as interest rates have risen. No wonder these people are feeling testy.

You rarely hear these people bemoaning their fate. That's why I was impressed by a Wall Street Journal article this week in which several investors candidly acknowledged that they couldn't take the pain of a plunging stock market and had bailed out, in some cases at or near the market bottom in March. I appreciate their honesty, and I'm sure their sentiments were shared by many others less forthcoming.

There's no reason to be ashamed of a decision simply because the market moves against you. No one is right all the time, and there's no way to predict where markets are headed, which is why I resolutely avoid such forecasts. But these are important learning experiences that should help people untangle their emotions from rational investing.

In my experience, investment decisions based on emotion, however satisfying in the moment, almost always turn out to be mistakes. As stock markets continue to rally, greed is emerging as the dominant emotion, and it's just as pernicious as fear. I hear it from the many people who have been asking me if it's too late to buy stocks now, who clearly want to hear that it isn't. At least they're asking, which suggests some degree of caution and willingness to think through the decision. Others are buying now, thinking about it later.

This is why I believe disciplined systems can be so helpful at separating emotion from reason. Asset allocation models serve this function, in addition to providing welcome diversity. If you follow an asset allocation plan, the recent stock market rally has driven up the value of your equity portion, and the slump in Treasurys has dragged that portion down. All else being equal, if you were at your equity allocation in March, you are now over it. To bring it into balance, you would have to sell — not buy — stocks now. Similarly, if Treasurys aren't part of your portfolio, you would be buying Treasurys now, not selling them. As is often the case, this simple exercise suggests that the rational decision is often the opposite of the emotionally satisfying one.

This doesn't mean investors can't buy stocks at a time like this. After writing about retail chain The Buckle (BKE) last week, I bought shares. To pay for them I sold shares in a consumer staples exchange-traded fund. This kept my overall market exposure the same, adding a consumer discretionary stock while selling a staple. As the economy shows signs of improvement, I plan to gradually shift out of defensive positions like consumer staples and health care and into more growth-oriented positions.

Meanwhile, I still have the cash position I raised by selling stocks in April (see "Figuring Out What to Sell in This Market"). With benefit of hindsight, that sale was premature, a decision for which I nonetheless remain unapologetic. As I've said many times, no one can time the market perfectly. I'm in no rush to put that money back into stocks. Last week's drop was a reminder that even bull markets suffer declines. Eventually there will be a 10% drop, which will be the trigger for me to put more money into stocks. No doubt by then, fear will again have made its presence felt.