For most people, losing money is much more painful than the joy of making money. When your investments experience a period of negative returns, that emotional pain can lead to bad choices. One of the most important skills of successful long-term investors is learning to take the emotion out of investment decisions. This is usually easier said than done, as we are all emotional by nature and all of our decisions are typically driven by emotion to some extent.
The last several years have been very good for most investors, but 2022 has not gotten off to a good start. As of the end of June, the S&P 500 was in bear market territory and down -20.4% from its highwater mark on January 4 (a “bear market” being defined as a drop of more than 20%). The tech-heavy Nasdaq was down even more at -30.4% since it’s high on November 22, 2021. If your portfolio lost value with these overall market reductions, you would do well to consider taking a deep breath and “staying the course.” If you are considering selling out of the market, you might want to take the following considerations into account.
Since 1928, a reduction of 10% or more in the US stock market (as measured by the S&P 500) has occurred on average every 19 months. A 20% (bear market) drop occurs about every 4 years on average. When they occur, market downturns can seem alarming, but they are in fact healthy for the market and act as a check on growth. The market is an imperfect system that is also subject to emotion; this results in periods of overbuying and periods of overselling where the overall market trend progresses in between these two extremes. Over the last 150 years (as well as the last 20 years), the long-term investor would do well to remember the historical upward trend in the US stock market has produced an average return of about 9%.
The “losses” that your portfolio experiences during a market reduction are not realized as a loss unless you sell. If you were to sell near the bottom of a correction (or worse at the bottom of a bear market), you lock in your losses. Such an action basically goes opposite to the traditional wisdom of “buying low and selling high.” When emotions take over, the cycle of buying high when there is euphoria in the market, followed by selling low, when the market is down and people are most pessimistic, will eventually lead to poor returns or complete loss of capital. That cycle will look like:
For another example of the adverse impacts of panic selling, consider what has historically occurred when you sell after a single-day market drop of more than 2%. The below graphic shows the historical returns for an investor who chose to “ride out” the market cycles vs. others who sold out and then decided to buy back in after certain periods of time. Over the last 25 years, the person who stayed invested significantly outperformed someone who sold after a market drop and then reentered the market after a period of time. Of course, if you time it perfectly, you might be able to improve performance but timing the market is usually easier said than done.
An “investor” is in the market for the long term and should not concern himself/herself with short term market behavior. Since 1928, just before the great depression, the market has produced an overall return of 6% before dividends, or 10% total return with dividends, as demonstrated below. The goal of the long-term investor is to capture appreciation while reducing the overall volatility in the market.
But, you might say, can’t I do even better than the market by selling at the market peaks and buying at the market troughs? First, this strategy needs to overcome the emotions discussed earlier, which is very hard to do. Second, consistently timing the market has proven to be an extremely difficult, if not impossible task. Many individuals have attempted to time the market and will succeed some of the time; however, consistent track records remain elusive. Ask yourself, if there is a person that can consistently time the market, wouldn’t we all be following that person and be rich by now? Even professional money managers have difficulty in consistently outperforming the market. Studies have shown that very few managed mutual funds provide returns exceeding benchmark performance over long periods of time.
So, what strategies can be employed for investors to capture long-term performance while alleviating volatility? The first and most important strategy is diversification. Even in times of overall market weakness, there are sectors or individual stocks in the investment world that will provide positive performance. For instance, commodities have been very hot over the last year, while the overall market has declined. It is very normal for one sector that performs exceptionally well in one year to have a down year the following year. This chart shows performance of various sectors for each year over the last 17 years.
Through diversification, investors can smooth out the short-term volatility and also improve performance over the long term. Performance is improved by combining assets that act opposite to each other. For instance, bonds have typically outperformed when stocks underperform and vice-versa.
Another effective strategy to unemotionally capitalize on market volatility is rebalancing. When you establish and invest in your portfolio, the percent allocated to each investment will match the target you develop. Over time, however, some segments of your portfolio will outperform other segments and your portfolio will drift “out-of-balance.” When the drift reaches certain limits (or at preestablished time periods), “rebalancing” can be employed where the appreciated assets are sold in order to purchase the underperforming assets. For instance, let’s just look at a simple 70% stocks and 30% bonds portfolio with drift and rebalancing demonstrated in the figure below.
Let’s say you start out in the upper left allocation. Over time, the stocks may outperform bonds such that the portfolio comes to consist of 85% stocks and only 15% bonds. Through rebalancing, the overallocation in stocks would be sold to purchase additional bonds, getting the portfolio back to the target 70/30 ratio. In this manner, you sell stocks at appreciated prices and buy the bonds. If a market pullback were to then occur with the resulting portfolio having ratio of 55% stocks and 45% bonds, the rebalance would be performed by selling bonds to purchase the undervalued stocks. In this manner, the unemotional process of rebalancing will tend to employ the “Buy low – Sell high” conventional wisdom by selling appreciated assets and buying the undervalued assets in your portfolio.
Another strategy that investors can employ to capitalize on market volatility is called “dollar-cost-averaging.” This strategy involves regular (i.e., weekly, monthly or quarterly) deposits and purchases of securities. If you establish a regular fixed deposit and securities purchase, you will buy more shares when the market is down, and buy less shares when the market is up. Again, this strategy provides a non-emotional means of trying to buy low and sell high that does not rely on trying to time the market.
As we have seen, investors need to employ a long-term outlook and diversify their portfolio for ultimate success. It is equally important that investors develop a portfolio that allows them to ride out market volatility and to not panic sell when the market takes a turn for the worse. One of the best means of successfully implementing these strategies and achieving success is to work with a financial planner to develop a plan appropriate to your situation and to help you implement the plan in an unemotional manner.
Please also keep in mind that the historical returns presented in this article are not a guarantee of future results and future returns may vary.
References:
www.money.com/stock-market-correction-chart
www.finra.org/investors/learn-to-invest/types-investments/investment-funds/mutual-funds/act