Comfort Zone Investing Case Study

Michael and Susan have been saving for retirement for 10 years. They are a composite from interviews and people I have worked with during the past 21 years. Since Michael’s major promotion 10 years ago, they have invested about $50,000 a year. Prior to that, they had less than $10,000 in investments. Now, stockbrokers, realtors, insurance salespeople, venture capitalists, hedge fund vendors, and other investment product peddlers have their number and routinely call them. Michael and Susan have compiled investments worth $450,000 during the past 10 years: half in a 401(k) and half in an online brokerage account. Immediately, you might notice the math. If they have invested $50,000 a year for the past 10 years, achieving a zero total return on their money, they should have $500,000 in investments. You might do the math, but Michael and Susan have not. You would also think that Michael and Susan would be happy with the size of their nest egg. Sill in their mid-40s, they are in the top 1 percent of wealth in the world. But they are miserable. Michael losses sleep over his investments regularly. Though he works 60 hours a week, he finds time several months a year to shift between $100,000 and $300,000 from one investment fad to another, believing he will increase his returns and then be happier with his portfolio. Among the other high-income employees where he works, this is routine practice. In fact, the main non-work-related topic among these employees is investing. Though not one of them has ever calculated their annual returns, they all constantly chase high returns and lose sleep worrying about the market. Susan, a stay-at-home mom and part-time consultant, is equally unhappy with their investments. She wants Michael to work less, even take early retirement, and consult part-time so he does not miss his children’s childhood years. She is certain they were happier before Michael’s big promotion. She is angry that their portfolio is in constant flux. She has no understanding of why one year they seem to have all their money in small cap stocks, the next year in municipal bonds, then in tech stocks, and now in hedge funds. She is convinced that they are on the verge of losing it all any minute and she will have to go to work full-time. You might think the case of Michael and Susan is unusual. It is not. Studies by Dalbar Inc. and others show that as many as 90 percent of individual investors underperform stock market averages because they buy and sell too often. In fact, studies by Brad M. Barber, Terrance Odean, Moringstar, and others have shown that individual investors make returns about half as high as the stock market. During 1970-2000 period when the market made 12 percent a year, individual investors made 6 percent. Individuals even underperformed the bond market by a significant margin. However, hiring professional money management does not solve the problem. Studies by Mark Hulbert and others show that professional money managers also trade too often and underperform the stock market 80 percent of the time. Unfortunately, all these studies focus on investment return.

Investing is not about numbers

Few investors realize that investing is not a numbers game. Making buy-and-sell decisions based solely on price movements is a strong indication you are outside your comfort zone. Buy at 5 and sell at 10 or buy at 10 and sell at 5 is trouble both financially and emotionally. Buy-and-sell decisions need to be made on the basis of knowledge of who you are as an investor, a fundamental understanding of the investment, and a determination of whether the underlying fundamentals of the investment meet your investment needs. If a company or mutual fund is having a bad quarter or a bad year or a great quarter or a great year, you need to understand how it is reacting to that situation and if its reaction indicates that it fits your investment needs. Price movements are external factors that tell you little about the company, the mutual fund, or yourself.
An emotionally mature adult would not make personal relationship decisions based solely on external factors. If you are in a new romantic relationship and your lover’s mother suddenly dies, do you end the relationship immediately (sell) or watch how your lover reacts to the loss of a mother and watch how you react to your lover’s loss. If your lover then inherits half a million dollars, do you make a decision to marry (buy) or do you watch how your lover reacts to new wealth and how you react to your lover’s financial gain. In a romantic relationship, your goal is to build a long-term positive relationship. Breaking up or staying together based on external factors such as a death or inheritance is clearly immature. The internal factors, your lover’s emotional development and your own, are the real basis for judging the long-term potential for marriage or a parting. The internal factors, your emotional makeup and investment policy, and the company’s reaction to success or failure, are the real basis to determine buy-and-sell decisions.
Investing outside the comfort zone is exemplified by basing trading decisions solely on price. Other external factors also influence investors when they are outside their comfort zone.

Investing is not about numbers

Few investors realize that investing is not a numbers game. Making buy-and-sell decisions based solely on price movements is a strong indication you are outside your comfort zone. Buy at 5 and sell at 10 or buy at 10 and sell at 5 is trouble both financially and emotionally. Buy-and-sell decisions need to be made on the basis of knowledge of who you are as an investor, a fundamental understanding of the investment, and a determination of whether the underlying fundamentals of the investment meet your investment needs. If a company or mutual fund is having a bad quarter or a bad year or a great quarter or a great year, you need to understand how it is reacting to that situation and if its reaction indicates that it fits your investment needs. Price movements are external factors that tell you little about the company, the mutual fund, or yourself.
An emotionally mature adult would not make personal relationship decisions based solely on external factors. If you are in a new romantic relationship and your lover’s mother suddenly dies, do you end the relationship immediately (sell) or watch how your lover reacts to the loss of a mother and watch how you react to your lover’s loss. If your lover then inherits half a million dollars, do you make a decision to marry (buy) or do you watch how your lover reacts to new wealth and how you react to your lover’s financial gain. In a romantic relationship, your goal is to build a long-term positive relationship. Breaking up or staying together based on external factors such as a death or inheritance is clearly immature. The internal factors, your lover’s emotional development and your own, are the real basis for judging the long-term potential for marriage or a parting. The internal factors, your emotional makeup and investment policy, and the company’s reaction to success or failure, are the real basis to determine buy-and-sell decisions.
Investing outside the comfort zone is exemplified by basing trading decisions solely on price. Other external factors also influence investors when they are outside their comfort zone.

Comfort zone investing is…

Comfort zone investing consists of knowledge of how different investments affect your emotions, knowledge of who you are in relation to investments, and choosing investments that match your personality.
The comfort zone is tested most often by large increases and decreases
in investment values. Studies of stock investors show that most investors react to declines in stock values by holding on too long-hoping the price will
improve. Investors also sell winners too soon to lock-in profits, missing even greater gains, and avoid purchases of bargain stocks that have declined in price fearing the declines will continue indefinitely. The net result is individual and professional investors consistently fail to make even half the stock market averages.
Many studies describe these phenomena. These self-defeating behaviors are attributed to thinking patterns such as “loss aversion,” the “disposition effect,” and “mental accounting.” Unfortunately, the studies only describe the patterns and the resulting low returns. The studies do not tell you why you are reacting dysfunctionally nor how to act maturely.
The comfort zone has three elements:
self-knowledge, investment knowledge, and matching yourself to the proper investments. If any of these three elements is out of place, your reaction to your investments will be dysfunctional. If you are in the right investments, you will act maturely. For example, many investors think that investing is solely about numbers. Unfortunately, focusing on numbers ignores both who you are and the nature of investments.