Wednesday, April 25, 2007

Handling Market Drops

"Great things are not done by impulse, but by a
series of small things brought together."

- Vincent van Gogh

So how did you mentally handle the 500 point drop in the Dow during the last week of February?

Hopefully you did not panic. Much has been written about the panic reaction to sudden market drops, so I'm not going to discuss that emotion. I think we all recognize that the panic emotion is usually a very bad thing, especially when it concerns investing. You have stay rational to make good decisions.

But what about other emotions one might have during the drop? Regret? Confusion? Anger? Pride? Surprise? Disgust? Frustration? Shock? Nervousness? Resignation?

Right now the market is relatively quiet, and now is the time to analyze your emotions and construct a plan for dealing with them during the inevitable future market drops.

For me, the emotion that dominates all others in a market drop is impulse. Note that this is a very different emotion than panic. I don't feel scared or upset, and I don't worry about how much further the market might fall. It's not a panic desire to get out of the situation, but rather a strong impulse to do something. As you can imagine, impulse is also not a particularly constructive emotion for investing!

However, I have long recognized this weakness of mine and have found I can put it to positive use. Since I so strongly want to take some sort of action during drops, I use the opportunity to end my procrastination with some of the mundane, mechanical investing tasks that need to be done. For example:

  • Filling out paperwork to combine similar accounts (e.g. two rollover IRA accounts)
  • Verifying beneficiaries for certain accounts
  • Making yearly contributions to IRA accounts, college accounts, etc
  • Organizing tax records for next year
  • Filling out paperwork to open a new account
  • Researching stocks and reading annual reports

I have found this really works for me. Instead of impulsively buying or selling things, I take action on the paperwork pile that's been sitting in the corner of the room. During a big market decline, I finally have the fire lit under me. I buckle down and slog through the paperwork to open a college account for my child. I get all the taxable transactions ready for next year's tax return. In short, I complete all the paperwork I've been putting off. I feel better about the drop because I did something, and of course I also feel better that I completed a lot of half finished tasks.

So what is your emotional reaction to large market drops? As you are no doubt aware, there is a silver lining to many negative emotions that can be harnessed for good. By planning ahead, you can turn those dips into a positive experience for yourself and your investments.

Friday, April 13, 2007

80% Redux

"The same conclusion may be reached from a different premise."

- James Henry Ferguson, The Philosophy of Things

The Journal of Financial Planning has just published an article by Ibbotson which discusses savings guidelines and capital needs for retirement. Although it is certainly not light reading, the article is well written and definitely contains some interesting information. What fascinated me most is that the authors arrived at nearly the same numbers that I did through entirely different means.

  • Retirement needs. The article suggested using 80% of "pre-retirement net income", which was defined as gross income less retirement savings. In a previous post, I explained why I don't think I'll need 80% of my pre-retirement income, and I suggested that retirement needs should simply reflect consumption level at retirement. However, I must admit that when I calculate my expected needs based on the Ibbotson formula, it does come out very close to my original calculations based on consumption.
  • Savings guidelines. The article used Monte Carlo simulations to estimate the required savings rate one would need to build enough capital to provide for retirement needs. Interestingly enough, the article came very close to the personal savings rate I eventually chose mainly through intuition as I watched my net worth grow.
  • Social Security. The article also discusses the non-linearity of Social Security benefits, which are skewed toward lower-income individuals. The article advises higher-income individuals to save at higher rates in order to compensate for this effect. This is not unreasonable advice. However, I also mention in a previous post about early retirement and Social Security that non-linearity and other aspects of the Social Security benefit formulas mean that higher-income individuals do not lose as much when considering early retirement.