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  • The Danger of Getting Out of Stocks During Bear Markets

    by Charles Rotblut, CFA

    One of the biggest risks to investors’ net worth is the portfolio decisions they make.

    Failing to adhere to an appropriate long-term strategy has a significant damaging impact on wealth. Since wealth is generated from the compounding of returns, actions that severely reduce an investor’s portfolio balance can have a long-term impact.

    A common dangerous action is panicking and pulling out of stocks during a bear market. Such an action limits the immediate damage to a portfolio, but can cause an investor to miss out on the big rebound that follows a large drop by not jumping back into stocks soon enough. Even being out of the market for just one or two years can cause a considerable amount of wealth to be forfeited.

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


    Discussion

    Chris Simber from NJ posted over 2 years ago:

    Great article...can never hear it enough, and appreciate the real-world data.


    Robert Christman from NY posted over 2 years ago:

    Excellent article.
    Some of us have been known to buyout-of-the-money puts during market declines-can be tax-efficient if you have gains on your stocks.
    As puts become profitable (market continues to decline), sell'em and buy lower strike puts.
    May not appeal to everybody.
    RAC


    Mirsa from Texas posted over 2 years ago:

    That data speaks loud and clear. Thank you for the research and writing this article.


    JERRY from MI posted over 2 years ago:

    WHAT ABOUT THE BUY IN NOVEMBER AND SELL IN MAY-NOT JUST LAST YEAR BUT THE LAST 30 YEARS


    Nathan Busch from MN posted over 2 years ago:

    I understand and recognize the validity of your analysis under the assumption that the investor is using various index funds. However, my recent experience with the AAII Model Shadow Stock Portfolio and the Stock Superstars Portfolio indicates that starting to purchase individual stocks, which were recommended by AAII, at the wrong time can be entirely devastating. For complete disclosure, I just recently started to invest using the AAII MSSP and the Stock Superstars.

    For instance, the recent additions of AVD, TTEK, JAZZ, PKG, OMCL as recommended by AAII have devastated my portfolio. Even if the future growth of the recommended portfolio were at 10% per year, it would take at least 2 to 3 years to recover from the losses. If one has 40 years or so until retirement, then the 2 to 3 years is relatively insignificant. When one has 5 years until retirement, such losses are a disaster.

    The situation is particularly problematic when one is following recommendations from those who hold themselves out to have at least some elementary knowledge of investing. Since AAII has, to my knowledge, never revealed the complete set of rules for selecting a stock for the AAII MSSP and the complete set of rules for selecting the Stock Superstars remains a mystery, then one must rely upon the credibility of the individuals who have created the model portfolios. The situation is, then, ripe for abandonment of an investment strategy not because the individual is not in control of his emotions with regard to a particular loss/gain scenario; rather, the abandonment will occur because the individual making the suggestions has lost credibility in the eyes of the investor.

    Upon this basis, then, your analysis is deeply flawed. To properly examine the actual dynamic, you should analyze either the AAII MSSP or the Stock Superstars Portfolio to examine the following question: what will happen to the portfolio of an individual who invested based upon the suggestions of the AAII and those suggestions turned out to be demonstrably wrong in the first place? Should that person stay or should that person realize that the person making the suggestion has lost credibility and figure out how to fix the problem by some other avenue?

    The results of such a study would be far more useful to the individual investor than merely giving platitudes based upon a completely artificial scenario.

    Nathan A. Busch


    Peter Rukavena from NY posted over 2 years ago:

    Nathan,

    Sorry about your loss, you are right on. I am a fellow MN. threw blood my dad was born in Aurora / Virgina MN.

    I am a 63 year old former CEO now semi -retired college business prof.

    There is no newsletter or service out there that will allow you to beat the market on any consistent basis.Many of them them will force to over trade , which will lower your return.

    If you look at their performance records it very much based on when you got in and owning all their recommendations at the right time.


    Nadia from NY posted over 2 years ago:

    Thank God my husband withdrew completely from stocks and into the money market in the beginning of 2008 and stayed away from stocks the entire year. Sure, we missed the beginning of the bull market, but so what? We are MUCH better off now then if we stayed fully invested through 2008.


    Richard Abbott from FL posted over 2 years ago:

    An article written in the AAII Journal dated January 2009 by Dale Domian and William Reichenstein called "STOCKS FOR THE LONG TERM: WHY PROSPECTS ARE ROSY". THIS ARTICLE SAID "STAY THE COURSE" - DO NOT BAIL OUT OF STOCKS NOW. This article saved me over $100,000!

    I never sold any stocks and kept my allocation the same - now I' up over 200% from the February 2009 lows - thank to AAII's article.

    Sometimes the "BEST" thing to do is "NOTHING"!!!


    Paul Hendrickson from MI posted over 2 years ago:

    As an 86 year old invester, I am no longer a long term invester. Therefor, I must watch closely when markets turn downward. I have used stop losses,and have determined when to. sell and stay in cash until the market looks appealing again.

    It's hard to recover from too large losses when stocks start it rise again.


    John Hawk from MA posted over 2 years ago:

    Hi Charles,

    Informative well-written article on the perils of Getting Out of Stocks. It seems like it may have a touch of confirmation bias in it, though, in that you chose a Panic scenario for getting out of stocks. A number of financial services provide systematic, non-panic-driven approaches to timing the market, on the theory that avoiding most of the bad times is worth giving up some of the good times. It would be interesting to see the current 3 scenarios compared against a more optimistic 4th scenario that times the market in a systematic way — perhaps using a moving average crossover criteria or some other non-proprietary mechanism. If this 4th scenario also comes out inferior in practice to the buy-and-hold and buy-and-rebalance approaches, I think your conclusions against timing the market would be much stronger and persuasive.

    Regards,
    John


    Richard Sherman from TX posted over 2 years ago:

    If someone has the courage to buy stocks with each 5% drop in the market and there has been a large bear market drawdown, don't start the sell routine with the first 5% pop. Wait until the market has partially recovered before starting to sell.

    Since we are at new highs, I think we should consider selling high. If someone is 60% stocks then go to 50%. After a significant drawdown, add the 10% back at the lower price.

    If someone is below where they would like their longterm stock allocation to be, I would suggest waiting until the next bear before adding stocks.


    Felix Ortecho from texas posted over 2 years ago:

    Even the smartest people can make decisions based only on emotions: panic.

    Great article, gives people to courage to do NOTHING.


    Robert Franzen from MO posted over 2 years ago:

    Charles,

    Thank you for an excellent article that quantifies the negative impact of market timing for the average mortal.

    Every time I read a similar article, I find myself intrigued about discussions of how investors pull money out of the market and huge sums accumulate on the sidelines. This is a very erroneous concept since every time an investor sells a stock and places the proceeds on the sidelines, the investor who buys the stock does the exact reverse and pulls money off the sidelines. I have never seen this phenomenon appropriately discussed.

    I challenge you to take this on as a future article, or perhaps invite the Phd's of the world to shine some light on this very "foggy" aspect of market activity.

    I would nominate John P. Hussman, Phd. to "wrestle with this tiger" and reduce its complexity to a level of understanding that us mere mortals can understand.


    JERRY from MI posted over 2 years ago:

    HOW WOULD YOUR SYSTEM WORKED WHEN YOU STAYED 70-30 FROM NOV 1 TO MAY 1--- AND FROM MAY 2 TO NOV 2 YOU WOULD BE INVESTED 20-20-60CASH NOT FOR 2 YEARS BUT FOR THE LAST 20


    Walter Caldwell from FL posted over 2 years ago:

    I would like to see a future issue address the dilemma of how an investor who is fully invested in stocks should go about raising capital from his existing portfolio to invest in a downturn/bear market given that all stocks are likely to be cratering at the same time.


    Franklin Jansen from FL posted over 2 years ago:

    Shouldn't there be a column in the tables (for the re-balanced portfolio) labeled "After Taxes" ? Or at least a few words on the tax consequences of re-balancing, especially if short term capitol gains are involved.


    Walter H. Weil from New York posted over 2 years ago:

    I read your article with great interest. I agree that many investors buy high and sell low, with the result that accumulated retirement funds are disappointing and inadequate. For the 79 million boomers at or near retirement age, a tragedy is in the making. Many of them will be "cash dead" before their lives end.

    Your chosen time period for the study, unfortunately, favorably biases the buy and hold strategy over the rebalancing one if one uses Shiller's CAPE valuation method. Your test period starts in 1988 with the S&P 500 Index at roughly fair value and terminates at the end of 2013 with the Index 50% overvalued. One would expect buy and hold to prevail during such a bullish interval.

    A fair test would be to start at a time when the market was 50% overvalued and end at the end of 2013. when it was at the same level of overvaluation. (For your starting point, you could find out from Shiller the date when the market became 50% overvalued between 1988 and, say, the market top in 2000.) I suspect the result of such a test would render rebalancing the unequivocal winner over buy and hold--with a higher return, lower risk, and lower drawdown.

    Even with your chosen test period, it is debatable which strategy is preferable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% and drawdown by 23% to achieve a 2% greater ending portfolio value isn't attractive to me. For some it might be.


    Doug from NY posted over 2 years ago:

    Robert Franzen wrote:
    Every time I read a similar article, I find myself intrigued about discussions of how investors pull money out of the market and huge sums accumulate on the sidelines. This is a very erroneous concept since every time an investor sells a stock and places the proceeds on the sidelines, the investor who buys the stock does the exact reverse and pulls money off the sidelines. I have never seen this phenomenon appropriately discussed.
    ......
    I think you may be right for CASH ACCOUNTS, in general. However, isn't it true that the "liquidity-providing entities", who populate the order books with limit buy and sell orders, are largely MARGIN ACCOUNTS? In which case, at least in the short run, you don't really have, on the opposite side of the trade, a matching "deficit" as investors sell, or a "surplus" as investors buy.


    Walter Weil from New York posted over 2 years ago:

    I read your article with great interest. I agree that many investors buy high and sell low, with the result that accumulated retirement funds are disappointing and inadequate. For the 79 million boomers at or near retirement age, a tragedy is in the making. Many will be ""cash dead"" before their lives end.

    Your chosen time period for the study, unfortunately, has a bias in favor of the buy and hold strategy over the rebalancing one. Your test period starts in 1988 when the S&P 500 Index was approximately at fair value and terminates at the end of 2013 when it was 50% overvalued. (I use the Shiller CAPE valuation method.) One would expect buy and hold to prevail during such a bullish interval.

    A fair test would be to start your study at a time when the Index was 50% overvalued and end it at the end of 2013, when the market was at the same level of overvaluation. (For your starting date, you could find out from Shiller when the Index became 50% overvalued during the period from 1988 to 2000.) I suspect the result of such a test would render rebalancing the unequivocal winner over buy and
    hold--with a higher return, lower standard deviation (risk), and lower drawdown.

    Even with your chosen test period, it is debatable which strategy is preferable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% and drawdown by 23% to achieve a 2% greater ending portfolio value isn't attractive to me. For some, it might be.


    Charles Rotblut from IL posted over 2 years ago:

    Franklin,

    If rebalancing is done on a periodic, annual basis, short-term taxes will largely be avoided. The tax impact can also be minimized by using IRA and 401(k) accounts to do the rebalancing instead of taxable accounts.

    Not rebalancing and letting the portfolio just ride will have lower costs. It will also result in greater volatility, which in turn could lead to a greater chance of panicking.

    -Charles


    Adam Gallucci from MA posted over 2 years ago:

    Excellent article. I approach my retirement account management with a fairly strict asset allocation model with rebalancing. As mentioned in the article, reducing a highly performing asset may limit upside if that asset has yet more gains to occur. What I often wonder about is: has anyone done a statistical analysis of using technical indicators to further refine buy and sell decisions that are primarily driven by asset allocation indications? We are in an era where moving averages, MACD graphs, etc are readily available on line.


    Walter Weil from New York posted over 2 years ago:

    I read with great interest your article "The Danger of Getting Out of Stocks During Bear Markets." I agree that many investors buy high and sell low, with the result that accumulated retirement funds are disappointing and inadequate. For the 79 million boomers at or near retirement age, a tragedy is in the making -- many of them will be "cash dead" before their lives end.

    Your chosen time period for the study, unfortunately, is biased in favor of the buy and hold strategy over the rebalancing one. If one uses Shiller's CAPE for valuation purposes, your test period starts in 1988 with a stock market (S&P 500 Index) at roughly fair value and ends at the end of 2013 with it 50% overvalued. One should expect buy and hold to prevail over rebalancing during such a bullish interval.

    A fair test would be to start at a time when the market was 50% overvalued and end at the end of 2013, when it was at the same level of overvaluation. (For your starting point, you could find out from Shiller the date when the market became 50% overvalued between 1988 and 1999.) I suspect the result of such a test would render rebalancing the unequivocal winner over buy and hold-- with a higher return, lower risk, and lower drawdown.

    Even in the case of your chosen test period, it is debatable which strategy is preferable. It really depends on one's risk orientation. I, for one, prefer rebalancing. After all, to increase one's risk by 12% and drawdown by 23% to achieve a 2% greater ending portfolio value isn't attractive to me. For some, it might be.

    I hope this email stimulates you to retest without the bias.

    Best regards,

    Walter Weil


    Walter Weil from New York posted over 2 years ago:

    I called AAII this morning and left a message with you that I was interested in knowing whether you ever received my comment.

    If you are interested in testing your findings over another interval of time, you might start at the end of 1995, when, according to Shiller's CAPE Index, the S&P 500 Index was 50% overvalued, the same level of overvaluation as at the end of 2013.

    Best regards,

    Walter Weil


    Craig Schaefer from NY posted over 2 years ago:

    Charles,
    Could you comment on the reason for using 30% of funds in bonds (70/30 allocation) if an investor is going to do nothing and ride out a downturn. It seems investors would be better off if they stayed 100% in stocks with this philosophy.


    Charles Rotblut from IL posted over 2 years ago:

    Craig,

    The assumption is that the investor wanted a diversified portfolio and initially followed our moderate asset allocation model.

    If you want to see how the results would have looked with a different allocation, the spreadsheets I used can be downloaded from above. (See the "Complete Data for All Portfolios and Variations" section near the end of the article.)

    -Charles


    Albert Mooiweer from CA posted over 2 years ago:

    "The Danger of Getting out of Stock during Bear Markets".
    This danger clearly exists based on cash outflows and inflows of equity markets. Where I disagree Is calling it panic selling by pulling out of stocks during bear markets. The idea is to get back in the market at a lower price.
    You assumed an investor pulled completely out of stocks whenever the S&P 500 fell by 20% or more (during a calendar year?) Then you are surely in a bear market. It seemed illogical to assume the investor to stay out of the market for 12 months. A year after the 2000 recession the market was still going down! After the 2008 recession the 12 month turned out to be not too bad.
    In 2000 the S&P 500 topped out at 1527.5 on 3/24, thus getting out at 1222.0, the next closing value of 3/12/2001 at 1180.2. Getting back in a year later on 3/12/2002 at 1165.6 ( at 99% of the value you got out) seems foolish as the market is still fluctuating.
    Let us assume that the investor gets back in equities when the market has recovered 20% from the bottom. The minimum closing daily S&P 500 was formed on 10/9/2002 at 776.8. Thus you would get back in at 932.2 or on the next closing daily of 934.4 on 5/6/2003. This is at 79% of the price you got out.
    Similarly, you got out of the market 20% below the top of 10/9/2007, you could get back in after a year for 71% of the value of the S&P 500 where you got out. Even better is to get in at 20% above the bottom for 65% of where you got out.
    There are many variations to get out below the top and get back in at a lower price. Consider MOVING AVERAGES, be it 100 days, 200 days or a year. At the crossover with an index you get your sell and buy signals. At the shorter averaging times you may get whipsawed occasionally, when you have to buy back in at a higher price than you got out.


    Joe Gass from OH posted over 2 years ago:

    Charles,

    Reference your article "The Danger of Getting Out of Stocks During Bear Markets".

    I enjoyed reading your article and the analysis within it. I thought it was very thought provoking. However, I am also curious on how making a couple of assumption modifications might have changed the outcome. The first change would be to see what the results impact would be with a 12% "Panic and Sell" percentage. The second change would be to use the 200 day simple moving average crossover as a re-entry point.

    I look forward to your response.

    Thanks


    Charles Rotblut from IL posted over 2 years ago:

    Hi Joe,

    I was not trying to create the optimal portfolio strategy, but rather wanted to show how dangerous panicking during a bear market is.

    The analysis used year-end data. If you want to adjust the scenarios, the downloadable spreadsheets have instructions for how the calculations are set up (see the "Complete Data for All Portfolios and Variations" box above).

    As far as the 200-day moving average, you would need quarterly or monthly data to better approximate it, as well as a long-term chart to show when the S&P 500 has traded above and below the trend line. Jeremy Siegel wrote about using the indicator in "Stocks for the Long Run" and I wrote a synopsis of what he said in my AAII Investor Update newsletter,

    -Charles


    Daniel Wagner from MA posted over 2 years ago:

    I don't understand how the drawdowns on the panic portfolio can be more than 20%? I thought the whole assumption of the panic portfolio was that all stocks are sold anytime the equity market has a loss of 20%? I doubt the 30% bond portion of the portfolio accounted for the rest of the drawdown, since bonds have done so well over the past 30 years.


    Charles Rotblut from IL posted over 2 years ago:

    Daniel,

    I assumed all changes were made at the end of a calendar year. During the two panic years (2002 & 2008), the S&P 500 fell by more than 20%.

    Investors who panic are not using stop loss limits. They are selling when they can no longer withstand the losses.

    -Charles


    Nick J. from Florida posted about 1 year ago:

    I am a simple guy with a simple investment strategy - buy good blue chip stocks that pay reasonable dividends with a history of increasing dividend yields. So, if you buy $100K of stocks that pay on average 3% dividends - if the market goes up or down, I am still getting the same cash flow since the number of my shares do the change with the fluctuation of stock prices. Only risk is if the companies cut back or stop paying dividends but I will take that risk into account in my selection of blue chip dividend stocks. It is like getting an annuity that pays 3%, with liquidity and potential future upside and without any stock maintenance costs (no mutual fund fees or investor fess). Would appreciate any thoughts?


    Tony from PA posted about 1 year ago:

    Your study results are very misleading and dangerous to the exact people you are supposed to be helping. The biggest misleading factor in your study is that fixed income or bond funds have been in a 34 year bull market since 1981. When interest rates are falling from 21% in 1981 to 0% today, that is very bullish for stocks as well as bonds.
    Since interest rates are currently zero, it follows that any investment in bonds in particular and stocks generally will be a losing strategy into the future. If you want a crystal ball into our future, just look at a country that has had basically ZERO interest rates since 1989--Japan. It's stock market has gone from a high of 38,916 in 1989 to 7,155 in 2009. Please tell them to buy & hold during those 20 years and re-balance every year. IMHO, I think that's what are future looks like. Those that fail to learn from history are doomed to repeat the mistakes.
    I personally buy 100% blue chip stocks (like Nick does in the comment above me) using a married put strategy that limits my downside to less than 4% and leaves my upside unlimited. Forget about bond funds unless you want to lose your money. When interest rates rise, bond funds go down. Of course, euro-weenies are buying negative interest rate return bonds. Tell me how that is going to end well.....unless you believe in the greater fool theory!


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