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Editor's Note

by Charles Rotblut, CFA

Editor's Note Splash image

Don’t panic.

This is the advice I’m giving in this issue. Regardless of how turbulent the market becomes, don’t panic. When it seems every pundit is predicting a worsening of economic conditions, don’t panic. When you see your portfolio dropping in value, don’t panic.

I could write a lengthy essay telling you not to panic, or I could show you how much wealth is forfeited by panic selling. Such an illustration would not pull data based on scenario analyses (e.g., Monte Carlo simulations), but rather it would use data from a portfolio an investor could have easily replicated and followed. I chose the latter based on conversations I have had with many people. The feedback I’ve heard is that while simulated data is nice, they would rather see what would have really happened over the last X number of years.

So, I ran the numbers. First, I used the 26 years of data I now have from my rebalancing models. Then I looked to see what would have happened if an investor’s timing was terrible and he got into the market either near the top of the tech bubble (January 2000) or near the peak of the housing bubble (2007). The message using all three time periods was the same: Don’t panic.

If you ever freaked out during a bear market and sold your stocks, you’re not alone. This is what many investors do. The decision to sell immediately stops the bleeding from the losses. But, and this is important, if you failed to get back into stocks when the market started rebounding, lasting damage to your portfolio occurred. A very large and significant forfeiture of wealth happens when an investor locks in losses (selling in a bear market) and misses out on big gains (failing to repurchase stocks when the market starts to rebound). You can see the data supporting this here. (You can also download the spreadsheets I used to calculate the data.)

The one point I didn’t make in the article—mainly because I didn’t want to digress—is the paradoxical behavior us humans engage in. We love bargains. We’ll negotiate over the price of a car, bring coupons to the supermarket and put up with the crowds in order to get a deal on the day after Thanksgiving. We’ll even check various travel websites for the best deal on airfare and a hotel. Yet we view sale prices on stocks as a bad thing.

As shareholders, we’re owners. From time to time, we’re also buyers. Since discounted prices are great for buyers, but bad for sellers, bear markets put us into a mental and emotional conundrum. We want the ability to both buy stocks on the cheap and have our portfolios increase in value at the same time. Since the pain of losses is greater than the pleasure of gains, during bear markets we ignore the sale signs popping up everywhere and worry about our declining level of wealth. Yet if any other item that we’d be interested in owning appeared on the clearance rack, we’d buy it.

There is a considerable amount of literature explaining why we make the financial decisions we do. What’s important to think about is how you have reacted to bear markets in the past. If you didn’t use them as buying opportunities, set up systems to work around your behavior. I think rebalancing can help. Maintaining a notebook with buy and sell rules is useful. Maintaining a list of stocks you would buy if their valuations became cheap enough is always a good idea. Mark your calendar with the dates when it’s time to look at your brokerage account and then don’t check it on any other date unless a stock violates one of your sell rules (e.g., bad earnings). A periodic visit with a good adviser may also make sense. Finally, consider following Warren Buffet’s latest advice: “If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.”

Wishing you prosperity,
Charles

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Charles Rotblut, CFA
Editor, AAII Journal
twitter.com/CharlesRAAII

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

Pete Stoehr from New York posted 3 months ago:

I did a study recently. over 20 years, there were only two times that the S&P did not recover within a few months (3-4 months, I think, possibly as much as 6 months) During those short recovery corrections, buy and hold was the optimal strategy.

In the two serious corrections, the 50 day simple moving average of the S&P crossed the 200 day simple moving average. If the SPY was shorted at these times in proportion to the (Portfolio Value x Portfolio Beta), and the short was closed when the condition reversed (50 day SMA exceeded the 200 day) there would be no loss, and possibly a profit (often Beta downn is less than Beta up). In the two other instances of the "Golden Cross", as I remember, the correction was shorter, and the strategy would yield a net zero gain/loss.

If you want an article on this I'd be happy to write one.


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