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.