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Should I Get Out Of The Market?

The following is a lightly edited version of a letter sent to FutureSafe clients on March 15 2020. It is reproduced here in the hope that it might be helpful and of interest to the broader investing community. Please note that the information contained herein might be outdated. As always, please consult your advisor or an investment professional before making any investment decisions. This information is provided purely for educational and informational purposes, and please remember that all investments carry risk which might cause you to lose some or all of your investment.

Hi All,

I’ve had some of our favorite clients call or email me over the past few days with variations of questions that go something like this:

We’re now officially in a bear market. I “know” equities will continue to fall (especially and at least for the next 2 weeks while the economy halts). “Knowing” it’s going down from here, why wouldn’t I go into cash (or all bonds)?

(I really love that this person’s sense of modesty put the “know” in double quotes!)

I’m going to give you one reason why that might in fact be the right thing for someone to do. But, I’m also going to give you my three reasons why it might not, so please read this in entirety before you decide which reason you like best 🙂

Let me start with why it might make some sense for someone to get out of the market at a time like this.

Do you have too much invested in the market?

It is undeniably true that the market could continue to go down. As I told you in my letter from a couple of weeks ago, the 12 prior post-war bear markets (yes, this makes this one lucky #13) have averaged a decline of over 30% with some drawdowns as bad as 60%. They have taken an average of 2 years to recover.

So, if your account has already dropped more than you thought you could stomach in the short term and this is keeping you up at night or giving you ulcers, you should consider updating your safety net.

Similarly, if you think that you cannot stomach continued losses in the coming months or even years, you might want to update your safety net.

In short, you should only take the risk that you can stomach. Now that we are in a downturn, if you have come to the conclusion that your risk appetite is not what you thought it was, it’s perfectly OK to acknowledge that and change your safety net accordingly.

But before you do anything, please read through and consider a few reasons not to do anything at this time.

OK. What’s reason #1?

Let’s start with this: If you decide to sell now (because of your conviction that it will go down) and plan to buy it back later (when you think it’s done falling), you are essentially making an active investment decision based on your subjective views.

Sadly, history suggests this is very hard to do.

Even professional investors who spend all day at this, do not appear to be very good at active decisions. The folks at the venerable S&P Dow Jones Indices regularly produce a fantastic report called SPIVA – S&P Index Versus Active. They find that a shocking 78% of active managers underperform their corresponding benchmark index over a 5 year period.

But, as they say, just wait – there’s more!

Active performance gets even worse when you look at risk adjusted returns (see the chart below, from a study by S&P’s Berlinda Liu  on their indexology blog – a most excellent destination for index nerds).

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The underperformance reported by SPIVA is remarkably consistent across regions, styles of investing and period, and is also echoed in academic studies across decades as well as Investor Behavior Studies such as the Dalbar studies that summarizes:

The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

That’s a lot of data. Can you summarize Reason #1 in one short sentence?

As my family keeps reminding me, I’m not very good at short sentences. But how about this:

We’re probably not as good at these active calls as we think we are, and it might hurt more than help.

OK. Reason #2?

If you watch the market on a day to day basis, the violent down days are awful – no question. However these jerky and volatile markets can also have explosive up days, and your attempts to time it might cause you to miss those up days. 

Here’s the kicker: It turns out that a large portion of equity returns are earned on exactly those huge up days.

What if you had missed just the top 15 days but otherwise stayed fully invested between 1990 and last friday?

If you had stayed invested all through, you would have earned just short of 7% per year.

If you had stayed invested but mistimed just the 15 best days, you would have earned 3.56% … which means that almost half of your returns over the past 30 years came on just the 15 top days.

Here is a chart that I created to illustrate that startling fact. Missing even just the top 3 days would have cost you more than 1% of your returns.

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Ouch. OK, but can you summarize Reason #2 in one short sentence?

Sure, I’ll try:

Missing just a few of the top up days, can cost you a large chunk of the market’s returns.

OK, reason #3?

My third reason to stay invested is that even large drops like the 2008 Financial Crisis and the 1987 crash end up looking like minor setbacks in the (very) long term.

If you really don’t need the money for a long period of time (e.g. 10 or 15 years) these are best to ride out because they look a lot better in the rear view mirror than when you are going through it.

Here is a chart of the S&P index from 1945 through to last Friday. Yes, the last section looks awful, but take a look at the drop of 1987 (where it fell 20% in a single day!), the dot-com crash of 2000 or even the “Great Financial Crisis” or 2008. In hindsight, they don’t look that bad do they?

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If you have a long enough horizon (10 to 15 years or more), the chances of doing well in the stock market is still quite good.

Summary Please?

If you think you overextended your risk budget, you can reduce your market exposure in one of two ways: first, you can move your safety net level up (i.e. set a higher safety net level), or second, you could shorten your time horizon. Either of these will likely increase your allocation to Treasuries and lower your allocation to the market. At the extreme, if you set your Safety Net Target Date to a year and your Safety Net to a number above your current account value, you will be 100% in Treasuries.

On the other hand, if you have the risk budget, there are a few good reasons not to react at this time and just look away from the wreckage while you wait for the markets to recover.

I hope that helps, however painful it might be. As always, if you have any questions, please email or call!

-Vijay

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Vijay Vaidyanathan, PhD