WHEN I was young, I heard wealthier members of my extended clan, usually the professionals on my father’s side of our family, say that investing in the stock market is risky. They are of the opinion that all excess money should be kept in fixed deposits in the bank.
Exercising caution is wise. Doing so is central to our long-term survival as an individual and as a species. We should be careful when crossing the street, driving our cars, riding our bicycles, climbing our chosen mountains, lighting matches, swimming in the ocean, choosing our spouse or career or worldview, and when indulging in the numerous other activities of a life well lived.
But if a caterpillar had the option to play it safe and to avoid all strange and unknown experiences, it would forever remain a slug and never become a beautiful, fluttering butterfly!
Thankfully, for the caterpillar, metamorphosis is hardwired by God into its DNA. Many aspects of human growth such as losing our milk teeth and gaining our permanent chompers are also imprinted onto our biological blueprint, and do not require any bravery to venture up the path of development and expansion.
Yet there are other aspects of personal growth requiring choices that involve defeating fear.
Our understandable terror of large financial losses in, say, the stock market can result in us choosing only low yielding cash savings that guarantee the erosion of our purchasing power through insidious, intractable inflation!
FACE YOUR FEARS
In Jason Zweig’s book Your Money & Your Brain, he points out: “... based on history, the odds that US stocks will lose a third of their value in a given year are only around two per cent. The real risk is not that the stock market will have a meltdown, but that inflation will raise your cost of living and erode your savings.”
In my financial planning practice, I help clients control their fears about their uncertain economic future and train them to face their understandable short-term fears so they can try to generate long-term portfolio growth rates that are higher than their long run inflation rate.
Interestingly, the mechanism which allows regular investors to handle steep, sudden (but generally short lived) dips in the risk-on portions of their portfolios is ensuring they have sufficient liquidity available in the risk-off components of their portfolios.
Those are the cash and fixed income (bond) elements complementing their riskier instruments.
In this regard, the job of a financial planner differs from a fund manager’s.
A good fund manager will harness the best investments available to generate optimal, hopefully, high returns. Such a manager often needs to find the optimum point balancing an investment’s risk (price volatility over time) and its reward (compounded returns).
A good financial planner, on the other hand, must invest time understanding his or her clients’ respective willingness to take risk, ability to take risk, need to take risk, and the time available to achieve a specific financial goal such as paying for a child’s university education in perhaps 12 years or funding a golden retirement in say 20 years or even affording a high quality international holiday in five years.
(Note: I have created the Devadason W-A-N-T model, which stands for a person’s Willingness, Ability, Need and Time to take on investment risk, to help raise people’s self-awareness concerning these variables in the calculus of investment risk assessment.)
Building wealth over long decades requires us to have a good understanding of our emotions so that we’re able to permit our rational mind to decide on a course of action that may appear frightening — such as adding money to a fund that falls in value over several weeks — to lower our weighted average unit cost and thus enjoy higher long-term compounded gains in the long run.
Zweig refers to the relevant governing parts of our physiology as our reflexive brain and our reflective brain. For human survival both are essential. The reflexive brain lives mainly in the amygdala.
We have two amygdalae, one in the right and the other in the left hemisphere of our brain. When we face a potentially scary or threatening risk, our amygdalae shoot up warning flares to our reflective brain, which lies mainly in the prefrontal cortex.
The prefrontal cortex has been described by neuroscientist Jordan Grafman as “the CEO of the brain”.
Zweig writes: “Another hub in the reflective network is the parietal cortex, back above your ears, which processes numerical and verbal information.”
Knowing all this is useful because for us to succeed as economic entities, we need to understand why we feel sudden spikes of fear and anxiety or the flipside of those, namely, irrational exuberance.
We then should train our minds to help us invest in a contrarian fashion IF the objective facts suggest that being fearful when others are greedy and being greedy when others are fearful is justified.
Therefore, invest the time and discipline to bring your money-related emotions under control by yourself.
Alternatively, farm out this profoundly difficult task to a carefully chosen client-centric (not mainly profit-centric) financial planner, private banker, unit trust advisor or wealth manager who utilises emotionless asset allocation and rebalancing techniques to curb reactions arising from inappropriate fear so as to enrich you!
© 2017 Rajen Devadason