The pitfalls of emotional investing

Since Sept. 30, 2008, doctors have had to digest an unprecedented number of large-scale financial events. The housing market that provided windfall profits to most homeowners tanked.

John K. McGill, MBA, CPA, JD, and K. Warren Poe Jr., CFP®

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Since Sept. 30, 2008, doctors have had to digest an unprecedented number of large-scale financial events. The housing market that provided windfall profits to most homeowners tanked. This was largely precipitated by the credit bust that left many wondering if the entire financial system was going to collapse. After a precipitous stock market decline that reached its ebb in March 2009, a sharp stock market rally ensued that caught many doctors off guard and underinvested. It's no wonder most doctors remain frustrated by their investment performance in the past two years.

Despite this recent volatility and the lackluster stock market performance over the past 10 years, most doctors have not given up on stock market investing. In evaluating doctors' investment portfolios as part of our comprehensive tax and business planning services, we have learned that doctors now have an average of 65% of their portfolio invested in stocks, up sharply from 50% at the end of 2009. As the stock market headed higher in recent months, doctors have increased their investment allocation in stocks.

"Making large shifts in the proportion of doctors' investments allocated to stocks can prove disastrous," says K. Warren Poe Jr., CFP®, an investment advisor with Select Consulting, Inc. He recently identified three different doctor-clients, each with a 60%/40% stock to bond ratio investment allocation, who each reacted differently to the stock market crash of 2008.

Despite the advisor's best efforts, the first doctor sold out in March of 2009, near the market bottom. Swearing off future stock market investing, he pledged that all current and future savings would be invested only in cash.

Currently still in cash, his return for the two-year period ending Sept. 30, 2010, was minus 17.1%. By selling at the bottom, he "locked in all of his losses," and he is sitting on the sidelines with growing frustration over recent stock market gains in which he did not participate.

The second doctor-client was talked out of "selling at the bottom." However, this doctor was so shell-shocked by the experience that he stopped investing future savings in stocks. As a result, his return has been up only 3.9% over the two-year period ending Sept. 30, 2010.

The third client fortunately changed absolutely nothing about his investing strategy during the stock market crash and ensuing two-year recovery period. This doctor left his account invested 60% in stocks and 40% in bonds during the entire time period, and continued investing new savings using the same allocation. This doctor was up 12.6% over the past two years ending Sept. 30, 2010. While the road was not always easy, this doctor was able to take his "paper losses" in stride.

He continued dollar-cost averaging his $5,000 a month savings into the market. The doctor's disciplined investing efforts were rewarded when the stock market began to recover in March 2009.

While the variation in investment performance over this time period using percentage gains and losses is informative, the magnitude of the investment losses by two of the doctors is staggering when the actual account values are reviewed. For this purpose, we assume that each of these three doctors had $1,000,000 invested on Sept. 30, 2008, and added $5,000 a month to their investments. Below are their respective investment account values as of Sept. 30, 2010:

Doc 1 – $946,719; loss compared to client 3: $318,248

Doc 2 – $1,173,242; loss compared to client 3: $91,725

Doc 3 – $1,264,967

Normally, doctors desire to increase their stock allocations when the market is rising and reduce them when the market is falling. While this is understandable from an emotional standpoint, the results above show how detrimental this can be to one's net worth. The difference between maintaining a disciplined approach to investing, and investing based on emotion, was more than $318,000 in this example.

Setting an investment strategy appropriate for one's age and risk tolerance during normal investment periods is the first step to successful investing. Maintaining it during times of market volatility is much more difficult and requires true discipline, but it can be tremendously rewarding.

John McGill provides tax and business planning exclusively for the dental profession and publishes "The McGill Advisory" newsletter through John K. McGill & Company, Inc., a member of The McGill & Hill Group, LLC. K. Warren Poe provides investment advice through Select Consulting, Inc., a Registered Investment Advisor and affiliate of The McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. For information on webinars presented by our firm, visit www.mcgillhillgroup.com/webinars.asp.

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