Transcript of the podcast:
MIKE TOWNSEND: Intellectually, we all know and accept that downturns are an inevitable part of investing, but 2022 has really put our resolve to the test. Even with some positive days last week, the S&P 500® is down nearly 15% for the year, the NASDAQ, more than 25%. So how are you handling it? Do you avoid looking at your 401(k) balance, or are you checking it every day? Are you converting everything to cash, or do you see this as a buying opportunity? Are you paralyzed by indecision, afraid to take any action with your portfolio, blocking CNBC from your television, or have you revisited your financial plan, talked to an advisor, rebalanced your portfolio? If you're feeling overwhelmed, you are not alone. Emotions play a huge part in investing and can really get in the way when the market is going down.
So how do we face our fears and make the right decisions for our own personal situation when dealing with this kind of market environment?
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.
Today, we're going to deviate a bit, and instead try and cut through the noise and confusion of the markets. In just a few minutes, Mark Riepe, host of Schwab's Financial Decoder podcast, will join me to explore the emotional and behavioral factors that can impact our financial decision-making. Mark will walk us through some of the most common ways investors get pulled off track in difficult market environments and offer some suggestions on how to avoid letting emotions and our own biases get the best of us when it comes to making decisions about our finances.
But, first, a few quick updates on some of the key issues here in Washington.
Last week, the SEC proposed new rules aimed at providing investors interested in environmental, social, and governance-focused investing, commonly referred to as ESG investing, with more information about how mutual funds and exchange-traded funds employ those factors when building their funds. The goal is to create some standards for when an investment can use terms like "'green"' or "'sustainable."' The SEC is taking action to address investors' growing concerns that companies and funds are engaged in what's become known as greenwashing, where they exaggerate their environmental and sustainable qualities in order to attract more investors.
Already on the books is a longstanding SEC rule, known as the Names Rule. It requires funds that have certain terms in their name that suggest a particular focus on a geographic area, an industry, a sector, or a strategy to invest at least 80% of their assets in holdings that meet that definition. For example, a fund that uses "Europe" or "European" in its name must invest at least 80% of its assets in European stocks. The SEC is proposing to expand the Names Rule to include ESG terms, so that a fund calling itself a "green fund" must invest at least 80% of its assets in investments that are suggested by that name. This proposal would also require a host of new disclosure requirements to give investors better insight into how the fund's name tracks with its investments.
A second rule would standardize disclosures to investors in fund prospectuses, annual reports, brochures, and other publications about how the fund considers ESG factors and measures its progress against those objectives. Funds that are specifically focused on ESG strategies would have to provide investors with a simple table that describes how the fund incorporates ESG factors into its investment decisions and disclose information about the greenhouse gas emission of the companies in their portfolios.
That last part is generating a lot of controversy, as it would require funds to rely on information provided by potentially thousands of companies, and that information may or may not be accurate. A 60-day comment period is now underway, after which the SEC will consider the comments received and decide whether to make changes to the proposal. Final approval could come by the end of the year. After that there'll be a one-year implementation period before the rules take effect.
But reaction has been mixed to the proposal. Investors have long complained that it's very difficult to compare ESG funds to one another, because exactly what it means to be a "green" or "sustainable" investment differs from company to company and fund to fund. The goal here is to make apples-to-apples comparisons easier for investors, and investor advocates are applauding the proposal for taking steps in that direction.
However, critics say that the proposals are another example of the SEC pushing a particular political agenda. Others have said that the cost and complexity of the rule could actually reduce the number of ESG-focused funds that are available in the marketplace. The only Republican on the SEC, Commissioner Hester Peirce, voted against both proposals.
Speaking of the SEC, earlier this month the Senate heard testimony from the president's two nominees to serve on the five-member commission. Both Democrat Jaime Lizárraga and Republican Mark Toshiro Uyeda sailed through the process and seem likely to be confirmed in the coming weeks. At the same hearing, more attention was focused on the president's nominee to be the federal reserve's vice chair for supervision, an important position that not only has a critical vote on monetary policy but is also the Fed's point person for the regulation of the nation's largest banks. Michael Barr, a former Treasury official now teaching at the University of Michigan, took some tough questions at his confirmation hearing, but all indications are that he has the support of all Democrats in the Senate and that Republicans will not make an attempt to block his nomination. If and when he is confirmed this summer, it would mean that all seven seats on the Fed Board of Governors will be occupied for the first time since 2013.
Finally, Congress is on break this week for the Memorial Day recess but will return next week to an uncertain legislative agenda. Key Senate Democrats have reportedly resumed talks about an economic package to replace the long dormant Build Back Better Act, which collapsed at the end of last year, but optimism remains low that a package can come together.
And the same sentiment applies to just about any other issue you can think of. On almost any hot topic, from combating inflation to dealing with border issue, to headline issues like guns and abortion rights, it appears nearly impossible to find a way to get legislation through the 50-50 Senate. There are a couple of exceptions. The House and Senate have each passed major bills that would increase the United States' ability to compete with China by doing things like strengthening our domestic semiconductor manufacturing capability and dramatically increasing funding for science-and-technology research and development. The two chambers last month began a formal conference to reconcile the significant differences between the two bills and produce a final compromise. That process has been slow, and it's expected to take several more weeks, but optimism remains that a final agreement can pass Congress this summer.
Retirement savings is another issue that has broad bipartisan support, and we think there's a good chance that a retirement bill could inch forward in the Senate legislative process this month or next, but even that's uncertain. Most observers believe a retirement savings bill is most likely to pass Congress in the post-election session in November and December, but not before the election.
There's a growing concern in Washington that last month's overwhelmingly bipartisan votes in the House and Senate to approve a $40 billion package of aid for Ukraine may be one of the last major pieces of legislation to pass Congress before the election. And, yes, there are five months to go before the election, but that's the reality of the current political situation in the nation's capital.
On my Deeper Dive today, I want to take a closer look at the emotional and behavioral aspects of being an investor, particularly in a down market like we have been in since the beginning of the year. In a market like this, it's very easy to be guided by stress and fear. Joining me now to help us understand how emotional and behavioral factors can impact investing decisions and what we can do about it is Mark Riepe, who heads up the Schwab Center for Financial Research. He's also the host of our sister podcast, Financial Decoder, which examines the cognitive and emotional biases that can have a huge effect on your financial life. Mark, thanks so much for joining me today.
MARK RIEPE: Yeah. Good to be here, Mike.
MIKE: Well, Mark, on your podcast, Financial Decoder, you talk about the various behavioral tendencies that can affect our thinking and lead us to make poor decisions in all aspects of our lives, but with a focus on our investing and other financial decisions. I'm so glad to have a chance to talk with you because right now we are faced with a very unnerving market situation. We've had a significant downturn, with the market flirting with bear territory. We have significant inflation, the supply chain is still hurting, it makes for a very stressful situation. So how does stress affect us as investors?
MARK: Yeah, stress is a really important condition, Mike, and I'm glad you brought that up. Stress, at least the way I think about it, is a double-edged sword. The good news is that stress causes our brain to get hyper-focused on the threat or the crisis that's in front of us. The bad news is that that kind of short-term thinking can cause us to make a decision that, while it may make sense in the short term, can create problems for us in the long run. And so when you're feeling stressed out, the first thing you need to do is ask yourself whether you need to make an important decision at that particular moment.
In most financial situations, you probably don't need to make a snap decision. And that's a good thing because you can delay it a bit until you're feeling less stressed and can come up with a better decision that really tries to balance both the long-term implications of that decision, as well as, you know, whatever short term pain you might be feeling.
MIKE: Well, Mark, I'm guessing that stress is kind of a gateway leading us into other biases and emotional decisions. I think it's normal to be very emotional about our investments and especially in this kind of down market. And it's been long enough since we last saw a down market like this that we don't remember how to act. No one likes watching the value of their portfolio go down every day, but a down market can also lead to an overreaction by investors. Why is that?
MARK: I think a lot of that is driven by something we call loss aversion. That's the idea that, let's say, if you lose a thousand dollars that hurts a lot more than the pleasure you would get from a $1,000 gain. In fact, for most people, you need a gain of $2,500 to offset the loss of $1,000. In other words, losses hurt about two and a half times as much as a gain feels good. And, you know, I don't think of that so much as a bias per se, because it's just how most people are wired, and because of that, we're willing to do almost anything to avoid that loss.
And so one of the things I think people need to do is they need to take a step back and ask themselves, "Well, what exactly is a loss?" I mean, right now the market is down, you know, about 20% or so from its all-time high. That's obviously unpleasant, but I doubt few listeners actually put all of their money into the stock market at exactly the all-time high or, you know, the all-time peak. What's the more accurate reference point? Well, a gain or loss relative to a recent all-time high or the price that you paid for it many years ago. I mean, relative to an all-time high is how we feel at the moment, and that hurts, but if we step back and look at the bigger picture, in many cases, things probably aren't so bad. Another way of thinking about this issue is don't assume that losses are permanent. Bear markets and corrections happen, you know, a lot more often than people realize, but diversified equity portfolios tend to bounce back over long periods of time, and they recover many of those losses and even exceed them because bull markets tend to be both longer and in magnitude more powerful than bear markets.
MIKE: Well, one of the most familiar phrases in the investing world is "past performance is no guarantee of future results." We see it on every disclosure, in every television ad, yet past performance seems like the place where a lot of investors thinking starts and ends. That's a form of recency bias, isn't it, where we ignore the history and focus only on what has happened lately? So why do we do that?
MARK: Yeah, Mike, you're exactly right. That is a real issue. We all do it. It's almost impossible not to do it. So I think of recency bias as the tendency to look at what's happening right now or in the recent past, and … that's exactly what you said, and then we extrapolate that far into the future. It's as if we expect whatever's been going on or just been going on, we expect it to, you know, continue that way forever. In other words, when times are good, we think good times are going to last forever, and when times are rough, we can't see any light at the end of the tunnel. And I think we do that for two reasons.
First of all, we've got a failure of imagination. By that I mean, we're consistently underestimating all the different things that might be happening in the future, both good and bad. And if we were more aware of those things, we would see that, undoubtedly, some of those things are going to happen and conditions are going to change.
Second, we've got a concept known as regression to the mean that we underappreciate. I was watching the NBA playoffs, and there are a lot of good players who go through periods of time when they're shooting poorly. I mean, they can't hit a shot. But if they're really good players, that doesn't last forever. Good players go through shooting slumps, but eventually they get back to their normal self. Similarly, sometimes you have below average players have a stretch where they're absolutely amazing. They can't miss, but it usually doesn't last, and they end up reverting back to their normal performance.
Markets are the same way. It's hard for an index like the S&P 500 to go up 20% year after year after year when the long-term trend is more like an 8% gain. Similarly, it's unlikely that it will go down 10% year after year after year when the long-term expected average is more like 8%. Markets tend to revert to their long-term averages over time, and we've always got to remember that.
MIKE: One of the things I think is interesting about this situation is that the bull market went on for so long that there are lots of investors who have, literally, never really experienced this kind of prolonged downturn, and even those of us that have, could, I guess, be forgiven for not remembering what it's like to experience this. So how do you get your thinking sort of reoriented so that you don't make mistakes in this kind of environment?
MARK: Well, first of all, I think it's always a good idea to just ground yourself in a little bit of history, and what do markets show over time as to what are the trends, what are both the upside possibilities and the downside possibilities, to ground yourself into a certain degree of reality. So that's probably the first thing to do. Secondly, you've got to review your reasons about why you're investing in the first place. And if those assumptions are incorrect, then it does make sense to change course. If you realize that a 20% drop in the market, you really can't sleep at night, and it's just causing you a lot of trauma, yeah, OK, maybe your risk tolerance needs to move more towards the conservative side. There's nothing wrong with that. But if the assumptions still hold, then should keep going on your course of action. And I think the other thing I would do is just kind of get out of your own head a little bit and, you know, talk to an advisor or talk to a friend who has some experience in investing and get some different perspective to, again, kind of open your eyes up to some things that maybe you're not thinking about.
MIKE: Let me draw a parallel to life here in Washington, D.C., where there's a tendency to react to things in the moment, to identify a problem and then start throwing solutions at it. There are plenty of examples of that going on right now here in Washington—think about inflation and the efforts on Capitol Hill to address that, or gas prices, the baby formula shortage. But, often, these are problems that cannot be solved by an act of Congress. Congress, obviously, can't wave a wand and make more baby formula appear on the shelves. Yet, I think here in Washington, there's this overwhelming desire to do something even if it is only the appearance of doing something. Do you think that applies to investors? Do investors just find it hard to take no action at all, even when that might be the right thing to do?
MARK: Yeah, I think a lot of us are wired that if we see a problem, we want to fix it. And, usually, if you want to fix something, just standing still and doing nothing is not going to fix the problem. So I think that's quite understandable. And politicians, as you just mentioned, they have to react to the expectations of their constituents. So it's not at all surprising that they do feel that way. But the advantage of being an individual investor is that you're only really accountable to yourself, and not to, you know, let's call them feckless voters. To be more precise, you're accountable to your future self. When you feel the urge to act quickly, you need to take a step back and think about whether what you're doing is going to be an action that you'll regret down the road. In other words, "What are the consequences of these decisions that I'm going to have to live with?" And if it's something you are going to regret, then you need to step back from the ledge and rethink whether that is, in fact, the correct course of action.
For example, if your portfolio drops 20%, and you sell everything, and then the portfolio starts to recover and go even higher, are you going to regret that? How are you going to feel if that, in fact, happens? If the answer is no, and you understand that a recovery is possible, and that the cost of selling is that you might miss that recovery, but you're comfortable with that because of the greater peace of mind you're getting, so be it. There's nothing wrong with that. That's just fine. But if the answer is, yes, you will regret it. You've got to rethink your approach because you're exchanging one emotionally fraught situation for another one. So, you know, maybe do something in the middle, maybe sell some, take some risk off the table, but don't go all the way, don't treat every investing decision as this big all in or all out sort of thing. It doesn't have to be that way.
MIKE: Let me keep my Washington analogy going for a moment. One of the things that happens here in Washington is that the political process is designed to be slow and deliberative that those heat of the moment decisions ultimately don't get made. When things are working properly, that should lead to better decisions. Unfortunately, it seems like our current political process has maybe gone too far in the opposite direction, where over-analysis becomes paralysis. Is there an equivalent to that in investing?
MARK: Yeah, I think at the end of the day, oftentimes, doing nothing is, in fact, making a decision. Let's say, you know you've got to get your financial life in order in some form or fashion, but you never actually get around doing it, then you're never going to be able to live through the benefits of that plan. Or, let's say, you go through the planning process, but then you never actually implement any of the recommendations that are contained in the plan because you're consistently procrastinating doing those things. I think that's a great analogy, where you're not really getting the benefits of why you went down that course of action to begin with.
MIKE: Well, I want to follow up on that planning idea. Even the best planners can panic when they feel a loss of control. Our colleague, Liz Ann Sonders, is fond of saying that panic is not an investing strategy. But it's also no one's strategy to lose money on their investments. The best planners out there can be pulled off course when things get really out of whack. So how does an investor avoid panicking and stick to the plan when it feels like that plan just isn't working?
MARK: That is such a common feeling, Mike, you're exactly right. I mean, Mike Tyson once said something like, "Everybody's got a plan until they get punched in the mouth." And I love that quote because that's exactly what losing money feels like. If your plan formulation process doesn't include an honest discussion about how much pain you're willing to endure, that emotional pain you're willing to endure from a loss, and how much pain you're financially able to afford to endure, then it wasn't really a good process. You know, practically every single year has a peak-to-trough period where the overall stock market drops, let's say, 10 to 15%. If that's a problem for you emotionally or financially, then you need to adjust your portfolio to something more conservative. If you have experience as an investor, you can look at your past behavior as a guide as to whether you really have that stick-to-itiveness. If you're younger and don't have that experience, start by investing smaller amounts so that you can get experience and get a better handle on how you handle the emotions of planning. What it comes down to is if you put together a plan, it can be the most well thought out plan in the world. But if you're going to bail the minute trouble comes along, you've got to rethink the whole situation from the beginning.
MIKE: Well, Mark, you've talked a little bit today about risk tolerance, which I think is something we often think we have a handle on. That's especially true, of course, when things are going well, we all have a pretty high tolerance for success, of course. But most investors have a much different risk tolerance when things are going badly. We all love that upside, when the market is going up, but we really want to run away from the downside when the market is not doing well. So how can someone find the right balance in that tension?
MARK: Look, in this respect, investing is no different than the rest of your life. To me, it's all about tradeoffs. Rarely can you have everything. And so what you've got to do … and, again, as I mentioned earlier, a good planning process will incorporate this concept … you got to be thinking of the potential consequences of your action. What might happen on the upside? What are the downsides? And lay those risks out there and realize, "If I eliminate this risk, I'm actually creating another risk. If I put less volatility in my portfolio by investing far more conservatively, for example, in short-term, fixed income investments, I'm reducing volatility, but I'm adding a risk to my portfolio because over the long term, I'm not going to have the possibility of getting those higher returns, and I'm going to have to save a lot more of my money in order to finance my standard of living, for example, in retirement." So be aware of those tradeoffs. And then at the end of the day, you've got to make a decision.
MIKE: Well, Mark, you talked a couple of minutes ago about something I want to follow up on, and that's this idea that I think one of the questions that drives us all absolutely crazy is when the media or investors talk about whether it's time to get in or get out of the market. And you talked about how it's not an all-or-nothing decision, that that's not a sound investing strategy either. Investing professionals who have studied market behavior constantly remind us that going with the herd is not a good idea. They try to guide us that when the market is climbing to the peak, maybe that's time to be selling. And, conversely, when the markets are at their worst, that may be the time to buy. So why do investors so often just follow the herd?
MARK: Safety in numbers. You know, I think somebody once said it's better to fail conventionally when everyone else is failing than to succeed unconventionally, because if we're doing something different from anyone else, and it doesn't pan out, we're going to feel that regret so much harder.
But the issue to me is that … again, I'll kind of go back to what I said earlier. It isn't the herd's money that's being invested; it's your money. And it would be surprising to me if the herd has your exact tolerance for risk, your capacity to take on risk. It would be a surprise to me if the herd has your goals and your timetable to achieve those goals.
When things go wrong, as they often do when investing, it is, after all, an activity that has some risk. The herd doesn't have to pick up the pieces and live with the aftermath. You do. So at the end of the day, it's your money, it's your situation, it's your life. You've got to make the decisions that make the most sense for you, not decisions that seem to make sense for other people who are probably in just different situations.
MIKE: Well, that sort of spills into this question of confidence. I know, for me, I like to have a certain amount of confidence in the decision that I'm about to make. And, of course, sometimes I'm very confident, and at other times I totally lack confidence in what I'm thinking about doing. I'd like to tell a story about when I joined Schwab more than 20 years ago. After I started at Schwab, the very first stock that I bought was Enron, and I was completely confident in that, and, obviously, that did not play out very well over the next few years. Can you share some guidance on being overconfident and underconfident, and how we can work with those emotions?
MARK: Overconfidence is a big problem because we all probably think we know a lot more than we actually do. And financial markets can be humbling that way. Your story about Enron, many people have that exact same story with not only just that company but other companies, as well, and other types of investments. So I think before you make that trade or buy that mutual fund or buy that ETF, you got to spend at least some time thinking about what can go wrong. And if that were to go wrong, what would the consequences to me be? And then in most cases, the answer is probably just diversify your portfolio more, so that at least you reduce those risks.
But, you know, people also suffer from underconfidence. I mean, the financial life … your financial life is important to you. And if you don't know a lot about, you know, personal finance or investing, that's fine, but it's still … that realm of the human experience is still going to have an effect on you, and so you're going to have to make some decisions in that area. And if you're underconfident about it, fair enough, then you need to either learn more or partner with somebody who has the requisite expertise, someone you trust, who can help get you pointed in the correct direction.
I mean, just think about, you know, medicine. I don't claim to know anything about medicine, but I know decisions need to be made regarding my health, and … because I get health insurance and talk to doctors periodically to help fill in the gaps with my own lack of expertise in that area to figure out. So, in some cases, I can be underconfident about betting on sports teams. Fair enough. I don't have to do that activity. You know, that's an activity I can just opt out of. But opting out of your financial life isn't really an option. You're going to have to make some decisions, and if you don't have the confidence, learn and start talking to people who do, and they can get you pointed in the right direction.
MIKE: Well, this has been a great discussion, Mark, and I think we should end with this. What should investors be doing right now in this current market to overcome some of these biases that we've been talking about and are maybe keeping us from taking that good guidance and making good decisions?
MARK: Well, I think, first of all, have a lot of humility. No one knows exactly what's going to happen with inflation, the Fed, the economy, wars, political activity in Washington. At the end of the day, even subject matter experts, they know plenty of things, but many of these things are very hard to forecast. So don't lock yourself into one particular course of action for a particular set of scenarios, because there's a good chance those things are not going to pan out. So that's the first thing.
Secondly, you've got to be as clear as you can about what you're trying to achieve and what risks you're willing to take to achieve those goals. Create a plan of action, a financial plan, a wealth management plan, whatever you want to call it, that balances those things as best you can, and then, get around to implementing them.
The third thing is, you know, no plan is perfect. You know, conditions change, we change, the environment changes. So be willing to make small adjustments along the way because the world isn't a static place, and neither are our lives. You know, you've got to have some flexibility.
I think the fourth thing, find trusted and competent sources of advice to interrogate our own thinking and the choices we've made. Find ways to try it and poke holes in our approach, and, again, as I mentioned just before, adjust as needed.
And I think the final thing is just … look, just be forgiving of yourself. Nobody gets everything right all the time. Make the best decision that you can, given the information that's available to you at a point in time. When mistakes happen, learn from them and move on.
MIKE: Mark, that's great advice to wrap up with, and I really want to thank you for joining me today. This has been a great conversation.
MARK: Mike, always love listening to WashingtonWise. Always listen to it in the car, either coming into work or going home. Absolutely love it.
MIKE: Well, thanks very much. That's Mark Riepe, head of the Schwab Center for Financial Research and host of our sister podcast, Financial Decoder.
Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. Take a moment now to follow the show in your listening app, so you don't miss an episode. And if you like what you've heard, leave us a rating or a review. That really helps new listeners discover the show. For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
After you listen
When the market gets volatile, turns downward, and keeps throwing curves, it can be hard to stay on track. Mark Riepe, head of the Schwab Center for Financial Research, joins Mike to explore how stress, emotions, and behavioral factors like loss aversion and recency bias can lead to making poor financial decisions that don’t fit with our long-term plan. They also share ideas for overcoming these influences and what investors should be doing in these challenging times.
Mike also looks at new SEC proposals for standardizing how companies and funds offering environmental, social, and governance-focused investing, known as ESG, describe their products and how they disclose information about their products to investors. He also offers updates on the progress to fill vacancies at the SEC and the final open seat at the Fed. And he lays out which of the dwindling number of bills that have bipartisan support could make it through Congress prior to the mid-term elections.
WashingtonWise is an original podcast for investors from Charles Schwab.
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