It certainly has been a challenging time and we look to the future in anticipation of better times ahead for all of us.
As we transition out of summer, we’re brought back to the awareness that as fall approaches and the foliage changes here in the northeast, we’re entering what has historically been a rather volatile season in the markets. With that, we’d like to again visit the topic of how to manage through volatility and perhaps what not to do.
The September – October period is an important season in the markets with which to be familiar. Going back to the beginning of modern markets in the 1920s, many of the most notable market events have occurred over this period. This is not meant to create unnecessary concern, but as investment managers, we cannot overlook the history. That said, each year we seek to come into the season with portfolios prepared and aware of the record.
Corrections and Bear Markets
One of the adages of successful investment management states that as an investor, you’re not trying to avoid corrections, you’re trying to avoid bear markets.
Corrections are exceedingly difficult to predict with any accuracy as to timing. It is understood by experienced investors that rarely, if ever, are corrections initiated by over-valuation alone. When asked in a television interview about this, Jonathan Golub, Head of Quantitative Strategy at Credit Suisse responded that forecasting a correction because of market valuation is like going to the doctor and being told that because you’ve been in such good health for so long, you’re due to get sick. Corrections almost always involve some unexpected triggering event and tend to recover over shorter time frames than many foresee. Given this, many insightful investors choose to look at corrections as buying opportunities, occasions to rebalance to a target allocation, or a time to stay put… rather than times to sell or exit markets.
Bear markets are identified as market drops of 20% or more, accompanied by deteriorating economic conditions, and generally last between six months and three years. Usually, the deeper the stock market declines, the longer the time to recovery. The decline and recovery in 2020, from March to August is an exception to this and a lesson in staying invested. The S&P 500 declined quickly and deeply; down about 34% from the February peak to the March low. Simultaneously, economic conditions crumbled. But, the rebound to the previous high took less than 4 ½ months.
Constructive Inactivity vs. the Action Bias
Years ago, the late Jack Bogle (founder of The Vanguard Group), when was asked for his advice to investors in light of the [then] current market volatility, responded…
“My rule — and it’s good only about 99% of the time, so I have to be careful here — when these crises come along, the best rule you can possibly follow is not ‘Don’t stand there, do something,’ but ‘Don’t do something, stand there!’”Jack Bogle
Constructive inactivity. In times of uncertainty, the idea of doing nothing is so contrary to what most of us are trained to do that it may seem ludicrous. In times of market uncertainty the compulsion to instigate change or attempt to reduce risk by exiting the markets can be overwhelming. But, oddly enough, given the evidence of market history, he was typically right. One only needs to look at a chart of the S&P 500 over the last 100 years or so to understand the reasoning. With the exception of those that invested during the four-year period around the beginning of the Great Depression (the bear market from February of 1928 to early 1932), investors in the stock market have generally been rewarded for perseverance, as the trend of the market has shown a solid bias to the upside. Certainly, there have been periods of significant negative volatility. But, it has rarely paid to sell out of the market because of a correction. Historically, recoveries from corrections have rewarded those that have exercised patience.
The challenge for many of us is that as Americans living in modern society, we have been instilled with beliefs and ideologies that lead us to behave in certain ways. This is accepted and, in many areas, helps us to navigate life, effectively, or even prosper in our culture. But as it pertains to certain aspects of investing, some of these same beliefs and behaviors can be self-defeating and present quite a challenge to overcome.
First, people tend to possess what behavioral scientists call an “action bias”. This is a predilection toward immediate decision-making, change, and the pursuit of control. The action bias compels individuals to take action, even when it might be better to do nothing. Often believing that most things can be improved with closer management, many people have a tendency to demand quick fixes. We witness a trend in healthcare where obesity and diabetes have become an epidemic. Higher numbers of patients with multiple options available to them are opting for the pharmaceutical quick-fix or elective surgery instead of practicing healthier lifestyles that could potentially provide better long-term outcomes. Most people understand that while bringing a sense of satisfaction in the short-term, this line of instant gratification often supports behaviors that can lead to greater issues in the future. While a good support system, plan, and exercising patience with the mind and body might show slower results, the long-term gain is often the more productive path.
High Time Preference vs. Patience
Second, many individuals have what is referred to by behavioral economists as a “high time preference.” This is the tendency to prefer immediate gratification over deferred attainment, often even if deferring attainment can provide a greater reward. This is the age-old view that “a bird in the hand is worth two in the bush.” This approach is escalating in personal financial practices in the U.S., where personal savings rates have fallen in recent decades, as many average Americans use revolving debt to live above their means rather than saving and investing. To the individual investor, the problem of high time preference lays in the fact that while some actions are effective in providing immediate gratification (or relief from anxiety), they can be simultaneously detrimental to the longer-term attainment of investment success.
Market Timing Presents Distinct Risks
“The average investor’s return is significantly lower than market indices due primarily to market timing.”
When markets show volatility, we often try to take action to wield some degree of presumed control, rather than doing what history and the research have shown to be in our best interest. But that action creates the need for other decisions down the road and those decisions may be much more difficult to render.
Bogle states that the challenge for investors isn’t simply to be right about getting out of the market when it’s declining. The challenge has much more to it than that. It’s knowing when to get back in. Most investors don’t get back in until things “look better”, but then it’s often too late. According to Bogle, if an investor tries to time out of a declining market and get back in later, to be successful they need to be correct on four very difficult judgments – two directional judgments, and two timing judgments:
- knowing that the market is falling toward a much lower level and not just exhibiting interim volatility (directional)
- knowing that a decline will remain for some period or to a predictable level (timing)
- knowing the approximate moment that the market has ended its decline (timing)
- knowing that the market then possesses the ability to deliver a sustainable upturn (directional)
If the investor is wrong on point #1, they are already in trouble because they’re behind the market and playing “catch up”.
If they’re wrong on point #2, they’re a victim of the dreaded whipsaw and can lose a lot of ground on the market.
Even if they’re right about the first two points, point #3 is usually where the best-laid plans disintegrate. Markets tend to form their lowermost level on what is known in the industry as “capitulation”. Capitulation is a belief that market conditions are so bad that recovery is not likely in the foreseeable future. When this level is reached, human nature leads us to an abundance of caution, even fear, that prevents most people from re-entering the market.
“Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”Warren Buffet
Most individual investors don’t spot the conditions that can spark or sustain a rally until the rally is well underway… and then don’t re-enter until levels are well above their exit point. If history shows us anything, and investors behave as they did through the market of 2007-2008, large amounts of potential return may be foregone due to investor fears. Being right about all that goes into a market timing strategy is highly unlikely for professional market participants, much less the individual retail investor.
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”Peter Lynch
Maintaining the Plan and Strategic Asset Allocation
For most of us, we’re saving and investing toward the goal of a secure and comfortable retirement. Most aren’t so financially independent that we can take big risks. Historically, timing out of the market to avoid a correction has created more risks than it has avoided. Normal negative interim volatility produces unwarranted fears in many of us. With those fears comes a compulsion toward actions that interrupt our financial plans and impedes progress toward our goals. Maintaining the focus on the longer-term horizon and staying with the plan has historically been a more secure strategy for investment success than market timing. This is especially true about investors that have maintained their appropriate risk-based asset allocation through interim volatility. Almost always, they have seen a recovery of their previous values, while other investors that “timed out” during negative volatility failed to re-enter the markets at the opportune moment.
We believe that successful retirement investing isn’t about continually trying to catch the next big thing nor is it about avoiding the next imagined meltdown. It’s about understanding all the small, mundane things that have been used successfully through time and applying them consistently. We at Atlas work daily to put those things in place and maintain them for our valued clients.
Of course, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor. They will be happy to discuss your specific situation with you.