Avoiding the Big Mistake

Featured Post | Published at Jul 7, 2022, 12:00 AM in investment strategy by Nick Maratta

Market volatility has many investors concerned, no matter where they are on their financial journey. Headlines and statement balances create panic, and often the need to “do something.” The feeling that markets are out of control, so reeling your portfolio back in – or selling it off – are common reactions to help regain a sense of equilibrium.

But making impulsive moves is never a good idea, and when markets are bouncing around, the costs can be very high and long-lasting. We think about it across three dimensions:

  • Review the fundamentals
  • Understand and manage emotion
  • Think small – incremental moves can make a big difference Let’s Go Back to the Fundamentals

The long-term history of the stock market is one of resilience. Even though there may be deep declines, the equity markets have risen over time. One other point we see from history: the depth of decline is not necessarily correlated to the time of recovery. While it can take years for equities to get back to neutral and then add value after a sharp decline, we’ve also seen periods when the recovery is much quicker, like in 2020.

The message is that timing the market is not a winning strategy. It’s too difficult to pick the exit and entry points and missing the best days in the market can be more devastating to overall returns over time. According to J.P. Morgan Asset Management:

  • Half of the S&P 500 Index’s strongest days in the last 20 years occurred during a bear market.
  • Another 34% of the market’s best days took place in the first two months of a bull market—before it was clear a bull market had begun.
  • From 1999 to 2019, if you missed out the 10 best days of the market in 20 yrs (meaning you were in cash) your return was less than 1/2 of what it would normally be if stayed invested.

Let’s look at how a portfolio is constructed, to get some perspective on what happens when markets increase and decrease. A portfolio asset allocation is built to adhere to a risk tolerance, by combining three asset classes:

  • Equities provide growth and generally have higher returns than bonds – and higher risk
  • Bonds have less volatility, but there is some risk involved and the return is generally income and capital appreciation
  • Cash is a source of short-term funds, but it loses value in inflationary environments

A productive way to think about risk is to make it personal. Risk is a measure how much volatility an investor can handle. When markets are on the upswing, investor risk tolerance increases. When markets drop, risk tolerance plummets too – leading to the urge to sell. This is the opposite of a “buy low, sell high” strategy.

So how can investors ground themselves? Difficult markets test your resolve – so it’s important to go back to your plan. Your financial plan is the blueprint to building the life you want and achieving your goals. If nothing has changed in your life goals, your plan should be still on track and built to meet them.

The plan drives the investments, not the other way around. That would be financial chaos. What can investors do when the bear is at the door? Focus on what you can control. The income you need, your spending and the distributions you take in a down market are to some extent manageable and flexible. Reviewing budgets, proposed big-ticket spending, and even day-to-day expenses can help you keep yourself on track.

Emotional Flooding Is Normal

How to manage emotions so you can be productive and proactive? First, accept the psychology. The fight/flight/freeze emotional reactional is very normal. But rather than get caught in a “doom loop,” there are exercises you can undertake that will help you regain equilibrium.

The best way to approach these is to formalize it – either pen to paper, your notes app, or even a spreadsheet.

Exercise 1: Perspective

  • Think of what is the worst that can happen?
    • Is that realistic?
  • “This time it’s different” (Is it really?)
  • History – Remember previous turbulent times
    • What did you do, how did it work out?

Exercise 2: Expand the Time Reference

  • How much income do you need in the next 2 years?
    • What spending can you put off?
    • What are immediate needs?
  • Would this be a cliff or pothole?

Exercise 3: Visualize Your Future Self

  • Two years from now, the market has recovered
  • How would you have like to have handled it?
    • Stressed out, sold everything, then stressed out on when to get back in?
    • Or remained calm, watched asset values recover without having FOMO or actually missing out

Keeping it Small

Sometimes tweaks or other moves are unavoidable. If you’ve thought through the above information, you should be in a more rational place to determine the minimum of moves that are necessary. You may need to raise cash now, but in order to recover, you’ll want to have the ability to replace assets when asset values are low. This is where minimizing spending comes in.

The Bottom Line

If you stay invested, your risk will eventually be rewarded. If you are able to manage spending and see the downturn as an opportunity to put excess cash to work eventually, you could come out in a stronger position than you started. But it takes time, managing emotions, and sticking to your plan.