As someone who deals with literally hundreds of clients a month, I am on the front lines when it comes to fielding concerns over investment performance. Here in the early parts of July, that means second quarter statements are going out. Statement time is always a busy time, but when you have a losing quarter, it gets even busier. We’ve had three consecutive relatively bad quarters, so the irrational decisions investors make are becoming more frequent.
So, in the coming weeks I wanted to do a mini-series covering the topics and concerns that come across my desk. I see a lot of interesting things and attitudes towards the economy and people’s investments, so I think some discussion would prove to be somewhat educational. To kick things off, I wanted to start with the most common reaction to the recent market–getting out of stocks and moving to bonds or cash.
The Typical Fair Weather Investor
I’m sure you know people like this, and you may even be one yourself. They are investors who never complain when their account is going up, and may even become more aggressive than they should as they reap the rewards, but at the slightest downturn, they do a complete 180 and move everything into a protective bond or fixed income shell like a frightened turtle.
Now, there’s nothing wrong with being thrilled with a strong performance and a bit upset over poor performance, but when performance alone dictates your asset allocation, you’re bound to do the wrong thing. Unfortunately, this is how most people I work with react if they don’t seek advice.
The Stop-Loss Rationale
When people decide to shift from stocks to bonds based on poor performance, they always use the stop-loss rationale. That is, if they switch to something safe, they eliminate the possibility for further losses. Does this work? Absolutely. If you move into an investment with a very small or zero chance of losing money, you have effectively stopped the potential of further losses. In most investors’ minds, this is a good thing.
But this rationale is nothing more than trying to time the market. By making the choice to move your assets into protection mode, you’re basically saying that you know for a fact the market is going to continue to go down. If it does, you’ll pat yourself on the back and congratulate yourself for a job well done. If the market goes up, you’re the one holding the bag earning minuscule interest while your old holdings may be recovering most of their losses.
Let’s examine the opportunity that can be lost when you guess the direction of the market wrong. If you’re down 10% during the first six months of the year and decide to move into a fixed account that is paying 4% APY, you’re basically locking in that 10% loss just so you can earn a guaranteed 2% on the remainder of the year. A $20,000 portfolio on January 1st would be worth $18,000 when you decide to move into the fixed account. Once you earn 2% on that money, your account at the end of the year would only be worth $18,320.
Sure, a $320 gain is better than any loss, but what happens when stocks rebound a little bit? Let’s say that stocks only recover half of their losses by year end. They are still down on the year, but had you just held on, your account would be worth $19,000. An even worse scenario is when stocks rebound completely and even see some gains. Let’s say that stocks make a comeback and finish the year up 3%. Had you held on, you’re be sitting on $20,600 versus your new fixed portfolio at $18,320.
This is all hypothetical, but it illustrates the fact that nobody knows what will happen in the coming months or years. You can try to stop the bleeding, but if you’re wrong, you’re missing out and just buying high and selling low. This is no different than trying to time the market by putting a lump sum investment in at the lowest point. If you get lucky, you’re a hero, but if you’re wrong, you’re a fool.
Ignoring Dollar Cost Averaging
The people I deal with are almost aways active participants in their employer’s retirement plan, which means they are adding money every two weeks. What most people fail to remember is that they are continuing to add money while prices are low, which is the same as buying items on sale. Sure, the market may be down, but now you’re also buying more shares while it’s down, which will benefit you even more in the future when things do turn around. Volatile markets are eased when you factor in the regular investments over time.
The worst thing you can do is to reduce, or stop your regular investments altogether. I actually heard this from someone this week:
I’m going to stop my contributions because I lost more money last quarter than I put in. If I wanted to throw money away, I would just go out and buy something.
This logic just baffles me. Sure, on paper if you look at money in versus market value of your holdings, you could see that you put $500 in and your investments lost $600. That doesn’t mean that you just threw away $100. You still purchased assets with your $500, and until you sell, it isn’t lost. Second, you saved money on taxes (assuming a pre-tax account). Your $500 contribution probably saved you around $125 in taxes, so that alone wipes out that $100 you think you threw away.
Taking Losses Out of Context
One of the biggest problems I see is when people focus on the raw dollar loss number without looking at it in context. Let’s look at two people who each lost $1,000 last quarter. What does that mean? For someone who has a $5,000 portfolio, that is very significant. But if someone saw that loss with a $75,000 portfolio, it should hardly be on the radar. Most people I see who are upset come in and focus specifically on the negative dollar amount with no regard to what it really means.
As a perfect example, I had someone completely irate that they lost over $5,000 in the past quarter. On the surface, yeah, that is a decent amount of money to lose in just a few months. But upon working with her and looking at their account, I realized she saw that loss on a $250,000 portfolio. Suddenly, that doesn’t seem like a big deal. When I explained that it was only a 2% loss while the markets are down double digits and they were doing quite well, they were somewhat at ease, but still insisted to move everything into a fixed account to stop further losses. I went back in time over the last few years and showed the gains that they made when the market was up where they at times were making close to $10,000 each quarter to show that this loss really doesn’t mean much. When things were put into perspective over the course of a few years instead of just three months, you could see a light bulb go on in their head.
Asset Allocation Works for a Reason
If you’ve determined that a 75% stock and 25% bond portfolio is suitable for your time horizon and risk tolerance, then that is what you should stick with in both up markets and down. This means you’ll capture most of the market gains in a bull market, yet you usually won’t realize as sharp of losses in a bear market. When you begin tweaking your asset allocation based on short-term market fluctuations, you’re only making things worse.
If you seriously can’t stomach some losses with your current allocation, then maybe you aren’t as tolerant of risk as you thought and should be more conservative. If that’s the case, you should change your allocation and then stick with that through good and bad markets. But for most people, trying to play portfolio manager and make changes based on how the economic winds are blowing will do nothing but hinder your long term performance.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
This is an interesting situation to debate, but I am on the side of Jeremy as far as being a contrarian. I wrote an article recently that proposed that the market has pushed the 'reset' button, allowing investment into stocks at prices not seen for years...
Excellent post. Although we mainly deal with short term trading, clients could heed the warning of ignoring the dollar cost averaging scenario. Investing for the long term is the key to a stable portfolio. Times like these need a cool head and not a knee-jerk sell off of your investments.
The post is so comprehesnive for me. It will be of great usage for sure. Ignoring Dollar Cost Averaging is my problem
Cannonfodder. What happens when interest rates go up? (with inflation rearing it's head, it's not unlikely) Then the interest on your loan increases and the value of your dividend portfolio drops (thereby raising div yields to compete w/higher interest rates). Do you have enough cash to cover your position if a margin call comes in?
Don't get me wrong. I agree that some stocks, especially financial stocks, are bargains right now. Bear markets can last a long time, though, and the herd may continue to drive the market down. Are you going to be able to weather the storm?
One big mistake people make is about their timeline. If you have time to let the market sort itself out, then more stocks seems to be the order. But if you are saving up for something <5 years away, a much larger portion of fixed-income would help you sleep at night.
Right, you don't completely avoid the taxes, but you add that $125 to your current cash flow, which is the mindset these people have anyway. They don't care about the possibility for gains and potential taxes 20 years down the road as they are looking at where their money is going paycheck to paycheck.
You're right. While being a contrarian isn't as popular, it can be effective. I'm in this boat myself, and have recently increased all of our regular investment contributions where possible. I have no problem buying more while people are selling and keeping prices down.
One behavioral characteristic you don't mention is the contrarian. When people are most negative, this is the time to start wading in and buying more. In fact, I'm poised to borrow money and invest it in dividend paying stocks. The after tax return of the dividends will more than pay for the after tax cost of the loan.
I'm much happier to do this now than I would have been less than a year ago when we are at all time highs.
You mentioned that you "saved" $125 in taxes (assuming a pre-tax account). What you've really done is deferred $125 in taxes. You do have to pay taxes at some point and although you might be in a lower tax bracket when you begin withdrawing from your pre-tax account, you will owe something eventually.
Individuals who over-react to gains or losses do not have a proper asset allocation for their risk tolerance. It is almost never correct to sell all assets in one class and move them to another class. Advisors have a legal responsibility to put their customers into a portfolio that meets their needs AND their tolerance for the volatility of the market.
This is a great idea for a series, Jeremy. People are indeed today feeling a good bit of confusion and panic. The only way that I know of for people to overcome those feelings is by taking them through.
I believe that the core problem is that the vast majority of investors is widly overinvested in stocks today. You can see that by looking at valuation levels. When people get too enthusiastic about stocks in comparison to alternative investment classes, stock prices get too high. People are too enthusiastic about stocks today (not because of how they have been doing for the past eight years but because of how they were doing for the 18 years prior).
I agree that many go through the process of lowering their stock allocations in a somewhat irrational way. The problem is that most do not today possess the tools needed to know when to cut back and how much to cut back. Discussions of when to cut back are often disparaged as efforts at "timing the market," as if that were a bad thing.
Some forms of timing are certainly bad. Some are good. What is most needed today is solid information of how to distinguish the good forms of timing from the bad forms of timing.
I tend to have the same initial reactions as you mention in this post. But I have been fighting hard to ignore them for many of the same reasons you talk about.
In my case last month (june 08) i lost $7000 on a total account of $127,000, which stings pretty good.
What particularly stings is that since I've been growing my account since start of 2005, the gains in the first 3 years have almost been wiped out by 2008 because the total amount has climbed steadily so that average returns of 12% in 2005 through 2007 can almost be cleaned out by a negative return of 10% in 2008 on a higher account value. :( that can make it hard to watch.