Originally published in Money and Finance, October 2019
Markets that experience sudden, sharp selloffs, like those we saw in the fourth quarter of 2018 and recently in 2019, see two things happen. First, bearish “sell everything” headlines appear everywhere. Second, investors struggle with the impulse to sell all their stocks and go to cash.
Bad News Sells
These reactions are understandable. The financial media knows that bad news sells, and investors are simply reacting based on survival instinct to protect themselves. The moment investors capitulate, however, they become market timers, often with disastrous results.
Hardcoded for Loss Aversion
Behavioral economists tell us that we as humans are hardwired to dislike losses about twice as much as we enjoy gains. During a market decline, our instinct is to try to prevent more losses, but ironically, that decision almost always leads to being out of the market for the gains that follow.
Investors will often justify the decision to liquidate assets during a decline with the presumption that they will be able to reinvest again when stocks resume their rise. This mindset is fundamentally flawed for two reasons. First, it’s statistically impossible for anyone to know when stocks will rise and fall. In addition, buying stocks (or anything else) after they’ve risen is counterproductive and counterintuitive, like waiting for the price of grocery items to go back up before you buy them.
The Cost of Missing the Best Days
The perils of market timing are frequently quantified in terms of the negative impact missing the market’s best days has on portfolio returns. According to data from Morningstar, investors in the S&P 500 index who stayed invested for all 5,035 trading days from 1999 through 2018 gained an average of 5.6% annually. If those same investors missed only the 10 best days over those 20 years, their returns fell to 2.0% annually, and if they missed the best 30 days, returns were a dismal -2.4% annually, replacing all their gains with annual losses.
You Can’t Avoid the Worst Days, Either
But what if the opposite were true, and market timing could be used to avoid the 10 worst days in the stock market? In theory, returns could be higher; however, that decision probably means not participating on the good days needed to produce higher returns, because 6 of the 10 best market days occurred within 2 weeks of the 10 worst ones!
Don’t Do Something, Just Stand There
Before jettisoning stocks in response to increased volatility or negative headlines, investors need to review why they own equities in the first place. Most would say it’s because they need the long-term growth that stocks have historically delivered to achieve their financial goals. And therein lies this simple truth: To realize the long-term growth that stocks provide, you have to be willing to stick with them through the highs and lows. After all, without volatility, there would be no reason to expect higher returns from stocks.
Investors assume the risk in order to obtain the long-term rewards. So, the next time there is a market selloff, don’t react; instead, heed the sage advice of late Vanguard founder Jack Bogle, who said, “Don’t do something, just stand there!” Remember, there is no such thing as market timing, only market (mis) timing.
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