Statement Shock-Perception Risk
U.S. stocks are cresting to all-time highs, almost daily. These are the times when investors look forward to opening their monthly statement. The anticipation is high, you open the envelope (or electronic statement) and wow, is that right? Shouldn’t the values be higher?
Today’s lesson is a phenomenon we are going to call “Statement Shock.” Inevitable questions follow. Rational people apply their problem-solving skills. They seek solutions to fix issues. They need to find out why they aren’t beating the market or at least keeping up.
Our article will focus on statement shock and what we should do about it. We will introduce the concept of perception risk. Perception risk comes from drawing conclusions based upon a focus on the performance of one asset class.
Investors need to protect themselves from irrational behaviors. Behavioral finance is a relatively new area of study for academics and has found that investors tend to receive a much lower return than the markets. Studies have shown that investors, as a whole, do the wrong things at the wrong times. For more information on the topic visit: http://www.investopedia.com/university/behavioral_finance/
When people compare their investment performance to the market, they tend to focus on U.S. stock returns. Their point of reference is often the DOW or the S&P 500. Comparing one’s performance to one of these indices is the basis of perception risk. If they are underperforming the market, they feel a need to address the issue by making changes to their portfolio or manager. Chasing performance is not good methodology when constructing a portfolio.
Most academics and institutional investment managers suggest portfolios of multiple asset classes. These typically include cash, bonds, real estate, stocks of many types, large companies, small companies, value stocks, growth stocks, international stocks, etc. The purpose of this strategy is to reduce risk by investing in assets that perform differently, at different times. Essentially, you want to avoid a feast or famine approach.
To date, U.S. stocks have been outperforming many other asset classes. People focus on the results of U.S. markets, and they want to participate fully in the upside performance. The problem is that U.S. stocks don’t always outperform. Additionally, most people don’t have portfolios that are 100% in stocks; this would be very risky. Do you want the (U.S.) “market” performance? Stocks in the US have indeed performed very well over the long run. However, there are seasons when they are way out of favor.
U.S. stock performance history reveals some good lesson. On October 19th, 1987 stocks lost 20% of their value on one day. Then from March of 2000 until October 9th, 2002 stocks lost 49.15%. Of course, most remember the Great Recession where U.S. stocks again declined 56.78%. An allocation dedicated solely to U.S. stocks can be a recipe for disaster. Furthermore, many investors tend to go to cash at these times only to miss out on subsequent stock recoveries.
It is important to stay invested for the long-term. To do so requires a disciplined approach and management of one’s emotions.
If you suffer from Statement Shock, today, understand a few things: First, since the U.S. Presidential election, U.S. stocks have hit all-time highs. If you own bonds, they have gone down in value due to interest rates rising by approximately one-half of one percent. If you own international or emerging market stocks, they too may have gone down. The reason for this decline is the US dollar has strengthened versus many of the world’s currency. If you have a properly diversified portfolio, some things are going up, and some are going down. In fact, these events should be considered normal; it is fine, you don’t need to be worried. It is all part of the process of achieving your goals long-term.