Volatility. It’s a word that has been use quite often when referencing the market these days, and for good reason. Volatility, by definition, is a tendency to change quickly and unpredictably – I think that sums up what we’ve seen from the publicly traded markets over the past 24 months. The question then becomes, how are you as an investor reacting to the volatility?
As an investor in publicly traded markets, you have choices, perhaps too many choices. You can buy or sell securities incredibly easily in the world today and the prices of your securities are at your fingertips, constantly flashing their red or green numbers throughout the day, updating in real-time. This is a nice perk of technology but can be incredibly problematic when it comes to how your brain is perceiving the information and how you are reacting to it. Let’s start there – with your brain.
As identified by Dr. Paul MacLean, your brain is made up of three separately distinct and evolutionary acting stimuli, called the triune brain. These three separate brains all serve a different purpose and communicate to each other differently and sometimes not at all! Understanding the roles each part of the triune brain plays, and how these roles can affect your decision making, particularly when it comes to money and investments, can be a huge factor in your ability to deal with volatility.
- The Reptilian Brain: the oldest, yet most irrational member of the triune brain. This part of your brain is hardwired into your head at birth and is constantly looking at the world through a lens of skepticism. The reptilian brain can be thought of as a radar, constantly looking for threats. The reptilian brain served all our ancient ancestors well, as they relied upon the reptilian brain to identify immediate danger and send a signal of how to avoid danger.
- The Mammalian Brain: the mammalian brain receives signals from your reptilian brain and acts upon them, with the objective to find momentary relief only. The mammalian brain is not a long-term thinker, not by any means. This brain uses the radar I mentioned above and decides to engage fight, flight or freeze. When used in accordance with the threats recognized by the reptilian brain, the mammalian brain will act accordingly.
- The Neocortex: the parent, the boss, the level-headed individual in the room. The neocortex is here to keep the two children (reptilian and mammalian) under control. The neocortex is where rationality, reason and long-term thoughts exist. The neocortex is who we want making final decisions on the large and important adult decisions we make every day.
Now, insert what we know of the triune brain into the decisions and investor makes when volatility and the talking heads on the television begin heating up. If the investor is thinking rationally and engaging their neocortex, they will be able to digest the opinions of everyone on television, understand that markets can be volatile, understand every business cycle in the history of business cycles has included recessions and may even have the foresight to understand that securities (depending on the geographic region) are now on-sale – creating an opportunity buy more.
Let’s look at a non-publicly traded example, and soak in the perspective of how we view prices in different manners. Meet my neighbor, John Doe. John is 55 years old and has decided to buy a home to use as a rental property for a long-term investment. John buys a home for $300,000 and immediately finds a renter who will pay him $1,000/month. John is now collecting $12,000/year in income from his investment in the home. John is very pleased with this, as he plans to keep this home as an investment for at least thirty years, and the income he is receiving from rent will help supplement his retirement, still at least 10 years away.
Now, let’s say I have a very strong pulse on the real estate market, and I knock on John’s door exactly one year after he purchased this rental home. I tell John, in today’s market, the rental home he purchased for $300,000 would sell for $225,000 today – John has lost 25%!
John, being a human being, feels the immediate twinge of his reptilian and mammalian brain giving him warning signals about problems and negativity and anger! His mammalian brain wants immediate relief from this issue – he is so mad about having bought a house that has decreased in value – what a horrible investment – who recommended he buy that house?
John, then realizing he is a very rational human being, takes a breath and consciously engages his neocortex. John realizes a few things that allow him to immediately put the issue to rest:
- A decrease in the value of the home does not mean he’s lost anything, despite my proclamation that he has lost 25%. You do not realize a loss until you sell the investment, a mistake I see many people make every day. Prices fluctuate, this is not new. Gains and losses are only realized once the sale has been made.
- This is a long-term investment. Throughout the buying process one-year ago, John never concerned himself with the short-term housing market prices. He wants to hold this house for at least another twenty-nine years, why is he concerned about what happens in the first 12 months, or even the first 60 months?
- He is still benefiting from this house, despite its decrease in value. The rent is being paid and he is receiving income – the value of the house is only important if he wants to execute the sale of the home.
Let’s compare the above scenario to owning publicly traded investments. Psychologically, what’s the difference? The difference lies in the day-to-day price fluctuations that we see on our computers, the day-to-day bantering on television about a “correction” or a “recession”, and the day-to-day experts who try to give us advice on selling and buying to capture the profit or to get out before it gets worse!
Compare the home that John owns to a well-diversified, publicly traded ETF for example. If an investor owns a security paying them a 4% dividend yield, and they plan to own the security for at least another 30 years, why on earth would this investor contemplate selling that security because the price has dropped? Rationally speaking, it makes no sense to realize a loss of that nature on such a long-term investment – but therein lies the problem. When it comes to publicly traded investments and the publicly traded markets, our neocortex oftentimes comes in third place in the triune brain.
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The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
The views expressed are those of BerganKDV Wealth Management. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investment advisory services and fee-based planning offered through BerganKDV Wealth Management, an SEC Registered Investment Advisor.
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