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Fleeing The Volatility Monster

32614239_sMy kids were flipping through the channels last weekend and came across some of their old favorite morning cartoons. They paused on the channel, laughing about how much they “used to” love watching them. (They are ages 11 through 15 but they acted like it had been decades ago.) In the cartoon, a monster dropped into the middle of a group of cartoon people at which point they all took off in a frenzied scramble in a million different directions, some getting turned around and running right underneath the monster itself.
 
I’m sure you can picture a scene like that in a cartoon you used to watch; it’s not all that uncommon. Or, if you haven’t watched cartoons lately, you likely have seen that behavior somewhere else, like in the markets! Have I lost you? Let me back up.
 
So far in 2016 the markets have been unpredictable at best, extremely volatile at their worst. In the wake of this terrorizing market monster, many investors are fleeing in a scrambled panic, which is evidenced by the higher trading activity we have seen in the past few months as investors try to escape feared equities to find safer investments.
 
According to one of the big 401(k) record keeper organizations, trading activity among its participants in just the first month of 2016 was the highest they have seen in three years, and 82 cents of every dollar that was traded moved from equity instruments to fixed income funds.
 
Just like the cartoon characters making panicked decisions about which direction to head, investors are making panicked investment decisions, many of which are leading them to poor choices and a dangerous future.
 
It’s understandable. The market, like I said, has been panic inducing. The S&P 500 dropped more than 5 percent in January alone, which was the worst stock performance for that month since January 2009. And despite the recovery we have had in the past decade, any statistic that references “since 2008” or since 2009” is going to bring up some PTSD for investors.
 
If you’ve noticed, I’ve used a lot of words to describe investment related decisions in 2016.
 
Panic. Fear. Terror. Stress.
 
People are making investment choices based on emotion. And although it’s human nature to let our emotions steer us in many aspects of our lives, an emotion-based investment “strategy” is never successful.
 
Investors who let their sentiment drive their decision-making will buy, then hold, then hit the panic button at the worst of times, when their threshold for pain has far exceeded its limit.
 
So, if we know we do not have the resolve to “buy and hold,” or the time to come back from a panic-driven decision, what can we do? Why not build a defined risk-on/risk-off strategy, thereby helping to eliminate decisions that are based on emotions rather than data and historical market trends? Why not create strategies that have specific rules? Is it possible?
 
The answer to this question is yes. One way to do so is to use risk triggers. Risk triggers are used in tactical investment strategies to filter out the day-to-day “noise” in security prices and provide downside risk management, which helps to protect investors from the volatility in the markets.
 
One such risk trigger may be a proprietary signal that utilizes a moving average to focus on the overall momentum of the markets, thereby revealing the longer-term market trend. With such a rules-based strategy, a confirmation signal would also be in place to help prevent portfolios from moving in or out of the markets prematurely.
 
A rules-based investment strategy based on risk triggers does two things: it protects investors in a downturn, and takes advantage of the upticks, all without relying on a single emotion. According to a study performed in 2014 by DALBAR, the nation’s leading financial services market research firm, the average retail investor earned just 3.69 percent when investing in equity funds, versus the S&P 500 Index returns of 11.11 percent over the same period of time (since inception of the DALBAR study on January 1, 1984).
 
You may be asking why there is such a disparity between the average retail investor’s performance and the “performance” of the S&P 500 Index if people are “buying and holding” and therefore just riding the markets? Primarily, because investors make decisions based on emotion instead of data. They “flee the monster” in any random direction, and often find themselves circled back right under the feet of the monster itself.
 
Decisions regarding your financial plan should not be based on panic. Stop running. Create a plan that is designed to send you in the right direction.
 
As Jeff always says, be vigilant and stay alert, because you deserve more.