The stock market declined by 4.4% in 2018. It was the first year stocks posted a loss since 2008. The S&P 500 rose 20% in 2017, 12% in 2016, and more than 13% annualized over the last decade. Yet, a one-year decline of 4% has caused all sorts of consternation. I admit that the peak-to-trough loss was much larger (17.5% so far), and the fourth quarter was one of the worst on record (down 13.5% in just three months).
The last quarter was a sobering reminder that investing in stocks involves risk. Most people understand that when the market is going up, but some seem to forget when it drops. Remember, there is no upside return without downside risk. Safe investments like T-bills and CDs pose no significant risk of loss to principal. Accordingly, they return very little. The yield on one-year CDs currently averages less than 1%. Certainly, everyone wants significant upside return with no downside risk. My daughter would like a fluffy unicorn to live in our barn…how fun would that be? Unfortunately, neither one exists. In order to get solid long-term returns, risk is necessary. Controlling risk, but not eliminating it, is the real objective.
A recent report showed that non-institutional investors flocked to bond funds in 2018, particularly ultrashort-duration and money market funds. Perhaps this shouldn’t be a surprise given the volatility and declines in the stock market. It makes sense that investors would embrace the safety of short-term bonds.
But does it make sense? Consider widely-cited research by Dalbar Inc. that shows retail investors, over a 20-year period, earned average returns of 5.2% compared with a gain of 9.9% for the overall stock market.
The Dalbar study showed that individual investors tend to buy into the market as it is rising and sell when it is falling. That means people would rather buy high and sell low, which is counterintuitive. I know from many client conversations over nearly two decades, that very few people believe market timing works. Indeed, there are numerous academic and real-world studies indicating the fallacy of such a strategy. In a rising market, everyone seems to accept that notion. However, when the market falls, emotions take over and acting in our long-term best interest seems to take a back seat to short-term comfort.
When we meet new clients for the first time, we always talk about the risk of the stock market. It is how we come up with target asset allocations for our clients. These discussions involve a review of historical losses in the stock market, and show that stocks can and have declined by 50% or more in really nasty periods. We then come up with a long-term strategy based on each client’s goals and risk tolerance. Yet, despite those discussions, market dips tend to trigger calls and meetings with the underlying question: Should we get out of the stock market?
The answer is always no. While it is your money, and you make the final decision, we always think getting out of the market entirely or lightening up on stocks because of market fluctuations is a bad idea. While it may sound self-serving, the real reason we believe this is that it will ultimately result in our clients having less money. We often hear stories of how folks got out of stocks just before the 2008 downturn, or that their gut feelings have never steered them wrong. However, we haven’t heard much about the times those calls didn’t work out. We haven’t heard many anecdotes about people’s losses in Las Vegas, either. The point is, we tend to remember the good calls we make, but forget the bad ones.
The Dalbar study, and others, are data-based reminders that when you consider all the calls we make, good and bad, the results are expensive. This isn’t just true of individual investors, there are numerous studies showing how even the most qualified investors are fallible (see “Beware of Experts Bearing Forecasts” article on our website).
The way to avoid these pitfalls: Tune out the noise and create a long-term plan that works for you and your family and stick with it in all market environments. There certainly will be uncomfortable periods, but they have happened many times before and the market has always found a way to rebound. Think back to how difficult 2008 was, and yet somehow we recovered and the market rose to new highs. There is no reason to suspect this time will be any different.
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