If you’ve managed to save a decent chunk of money over the years you’re probably wondering what to do with it.
Do you invest it? Buy real estate? Do nothing?
You’re watching the markets rise and you feel like you’ve been left out of the party. Everyone else is making money but you. FOMO (fear of missing out) is a natural reaction when you’re sitting on the sidelines.
Some people will act on that fear by opening up an investing account and putting the money to work. Over the long run that has worked for investors willing to ride out the ups-and-downs of the market. However, this is not a decision to be treated lightly.
What does your money represent?
There is a behavioural bias called ‘loss aversion’. It says that people react more poorly to losses than to gains of the same magnitude. In other worse, people prefer not to lose $10 than to gain $10.
While finance theory argues people should evaluate investments based on expected returns – the weighted average of all possible outcomes – in reality this is nonsense. Loss aversion is a behavioural characteristic grounded by millions of years of evolution.
In the past, losing a day’s worth of food could mean your family starves. In contrast, gaining a day’s worth of food (before we were able to store it) wouldn’t have an immediately positive affect on life. (Over the long-term, if an abundance of food consistently existed we’d simply add more humans.)
When it comes to your money, it makes sense to weigh losses more than you weigh gains. First of all, even a temporary decline in cash availability could lead to a missed mortgage or rent payment. This has a significant and lasting affect on your ability to enjoy life, especially if it results in homelessness.
However, losses have even greater psychological significance over the practicality of missed payments. Your savings represents all the time and energy you spent working over the years. If you’re like most people you’re not particularly fond of your job. You probably wouldn’t be there if you won the lottery.
Your savings is what you have to show for years of pointless meetings, directionless projects, crazy commutes, stress and even physical pain. (Remember, not all jobs are at the comfort of a desk. People in the trades often have a limited span during which their bodies can handle their work.) This is time that you’ll never get back.
In exchange for sacrificing significant elements of your life, you were paid and you saved some of this money. So you can see why losing a portion of this money creates hugely negative psychological consequences. It’s your life’s work encapsulated into a single number. Watching this number decline by 50% is like losing half your working life – you might as well have spent that time playing X-Box.
What to consider before you invest.
When it comes to investing your money, unless you have a lot of time to make up for your losses (i.e. you’re young, in which case you probably don’t have much to invest anyway), you shouldn’t invest anything you can’t afford to lose. Assume your investments could decline by 50%. Would you be comfortable with that?
Of course, the wealth management industry will point to long-term average returns on stocks and bonds when pitching to clients. However, the reality is that these averages smooth out wide year-to-year fluctuations.
While it’s true that (historically) if you you simply bought-and-held the index you would have achieved these average returns, it doesn’t consider the journey that individuals experience. This is precisely why people sell their investment after losing 20, 30, 40%+. It’s a stop-loss strategy on their life’s work. Although the US stock market has never gone to zero, each double-digit decline makes that risk feel real, so investors take action.
Of course, what ends up happening is investors lock in their losses and end up underperforming the averages by a significant amount over the long run.
Forget about FOMO. Ignore your friends bragging about their gains. This should not be what drives you to invest.
Instead, consider the losses you are able and willing to handle. Could you ride through a 50% loss without worrying about funding your retirement or paying your bills? Could you handle the psychological shock of watching 30-50% of your life’s effort evaporate?
My suggestion is to start with the stash of cash you need to stay comfortable – financially and emotionally. This goes beyond emergency savings that covers a few months worth of bills. This cash stash is your backup plan in case everything else fails. The size of this stash is dependent on how you answered the questions above. A young person living at home will have a smaller stash than a breadwinner supporting a family of 4.
Once you’ve stashed some cash you can then invest the rest. Although your investment portfolio will be smaller, your results might actually improve because you’re less inclined to sell after markets decline.
Your cash stash should help you get through market madness without emotionally reacting by preserving a significant portion of your life’s work.