In our nearly two decades of experience as a professional investment firm, we have seen one easy-to-avoid mistake recur frequently among fund managers and individual investors alike: selling a large chunk of one’s equity portfolio with the hope of getting back into the market later at knockdown prices.
The allure of timing the market can be strong. Selling a large part of your portfolio and then buy it back four months later at a 10% discount can feel very good.
However, the reality is that the odds of successfully pulling off such a trade are very low. More often then not an investor seeking to time the market ends up buying back in at higher prices. This can happen for two reasons: first, the investor may simply be wrong about the market direction. Second, even if the market does drop, the investor still has to have the emotional strength to buy back in. Even if the investor is correct in forecasting a decline, he or she often misses the opportunity to buy back in because of waiting for just another little drop! (“I think it’s still going down…”)
While it can be emotionally difficult to be invested during a decline in the market, the reality for the long-term investor is this: it is far more damaging to the long-term investor to miss out on a 10% up move in the market than it is to be in the market during a 10% decline.
Buying back into a higher market is very damaging for a portfolio as it represents a permanent loss of opportunity. By contrast, an equity investor who suffers a 10% drop in the value of his or her portfolio is actually not in a bad (or unusual) position at all. 10% “corrections” are actually quite common. Between 1950 and 2015, the stock market has suffered 34 corrections of 10% or more. And how many of these 34 corrections were subsequently repaired by a rising market? Every one. Every single one represented an excellent opportunity for shrewd investors to pick up stocks on the cheap.
What to Do
The way to avoid letting market’s volatility impel you to do something that costs you in the long run is really quite simple: have a target equity allocation for your portfolio—then stick with it! For example, let’s say you are comfortable with committing half of your investment portfolio to stocks. In the case of a market decline, your 50% allocation would probably also decline. The investor should simply buy more stocks during the correction to bring the portfolio allocation back to 50%. In the case of a rising market which pushes the equity allocation to 55%, the investor might consider selling some stocks to rebalance down to 50%.
We think equity investors need to keep their eyes on the long run and not try to prepare their portfolios for the market’s next 10% “correction.” Instead, they should be focused on keeping their exposure to stocks as the market doubles in value, on average, every 10 years. The U.S. stock market will assuredly decline 10% from it highs many times in the coming years. It’s actually a normal and frequent occurrence. Investors should ready themselves to scoop up shares at a discount by rebalancing to their target equity allocations with each 10% drop.
On paper, this is a simple strategy. The key is having the fortitude to stick to it after the market has just taken a tumble. Here’s that statistic again that should bolster your confidence: from 1950 to 2015, there were 34 corrections of 10% or more. And the market has recovered from all of them. If you don’t think that the market will recover from the next 10% decline, then you should not invest in equities!