This article originally appeared in the May 2014 issue of the AAII Journal.
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.
Buying High and Selling Low
Reactions to turbulent and bear markets vary by investor. Some are unfazed by large drops in stock prices and even view them as buying opportunities (“Buffett-like investors”). Others curtail their stock holdings when the market incurs a steep drop, but don’t completely pull out of stocks (“nervous investors”). There also are many who get out of stocks completely during a bear market (“panic investors”) out of fear of incurring further losses.
Panicking and pulling out of stocks during a bear market 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.
Why do many investors panic?
There’s a human inclination to be risk-averse. We feel the pain of losses much more than we derive pleasure from gains. Compounding matters, we humans commonly engage in hyperbolic discounting, which means we place greater value on rewards received sooner rather than later. When the market falls and stocks are sold, we see the immediate value of avoiding further losses. What isn’t considered are the potential future gains forfeited by not continuing to stick with stocks or, better yet, by rebalancing and allocating more money to stocks.
The net result of this behavior is a buy high/sell low mentality. When the markets are rising strongly, investors are more likely to put money into stocks (buying high). When a steep market correction or a bear market occurs, investors move to sell their stocks (selling low). Then once the market has rebounded and recorded significant gains, investors notice the profits they are missing out on and they put money back into stocks (buying high). This cycle results in a process of locking in big losses and missing out on big gains.
The buy high/sell low mentality is caused by loss aversion. When stock prices are rising and we don’t have a significant allocation to stocks, we feel the pain of missing out on market gains by not being allocated to stocks. When stock prices are dropping and we see our portfolios falling in value, we feel the pain of the lost financial net worth.
There are alternatives investors can follow that don’t involve correctly forecasting market direction, something most people fail to do on a consistent basis. The first alternative is to simply leave their portfolios unchanged. The second is to periodically rebalance. Rebalancing both lessens the blow of bear markets and gives an investor something to do during a bear market. The latter can play an important psychological role, since having a plan of action may help an investor regain a sense of control.
Rebalancing: A Better Method
If panicking is a big problem, a strategy that helps an investor to maintain a constant exposure to stocks should logically produce benefits. While some may view the best advice as simply being “don’t panic and stay allocated to stocks,” such guidance only works well for Buffett-like investors. All other investors need a strategy that gives them a sense of control. This is where rebalancing comes into play.
Rebalancing is the process of adjusting your portfolio back to your targeted allocation. For example, say your allocation calls for a 70% allocation to stocks and a 30% allocation to bonds. After a bad year for equities, your portfolio’s allocation changes to 60% stocks and 40% bonds. Rebalancing would prompt you to shift 10% of portfolio dollars out your bond holdings and into stocks, bringing your portfolio back in line with your targets.
Rebalancing is a buy low/sell high strategy—the opposite of what many investors actually do. It prompts you to buy assets after they have fallen in price. This may sound counterintuitive and may even be difficult to do the first time you try to employ it. Yet its bear market benefits may convince you of its value. Rebalancing lessens the blow of bear markets, making it easier to stick with stocks. In addition, rebalancing restores a sense of control. Rather than being left wondering what the best decision is for your portfolio based on what the pundits are saying about market direction, you have a strategy that prompts you to act and gives direction on how to do it.
One concern that keeps investors out of the market is a fear of investing at the wrong time. There is a psychological hurdle to investing when one is concerned the market could fall. Even Buffett-like investors don’t enjoy seeing a stock they recently purchased decrease in value. The problem with waiting for the ideal time to get into the market is that an investor may wait too long to do it. In other words, stock prices may make a significant upward move before the investor reacts and allocates to stocks.
The alternative is for the investor to cross his fingers and allocate in a manner appropriate with his long-term goals regardless of what the market is doing. Doing so, however, can put the investor at risk of lousy market timing—he gets in shortly before a market top is formed and stocks drop considerably in price.
The Negative Wealth Impact of Panicking
Figure 1 illustrates the change in portfolio value from 2000 (near the top of the tech bubble) to 2013 for three versions of a sample mutual fund portfolio. Even with bad timing, it is better to stay invested in stocks. An investor who started the 70% stock/30% bond portfolio in 2000 and never took retirement withdrawals but panicked at the end of 2002 and 2008 would have ended 2013 with approximately $76,000 (31%) less in wealth than an investor who rebalanced instead. The portfolio values at the end of 2013, assuming no withdrawals were made, were $242,973 for the rebalancing strategy and $166,806 for the panic strategy.
Panicking did result in a lower level of volatility for this sample portfolio. The lower level of standard deviation was accomplished by avoiding equities during the years with their largest upside moves. Since volatility only measures the magnitude of fluctuation but not the direction of the fluctuations, it can be lowered by avoiding good years, bad years, or both. Equity allocations also explain why the non-rebalancing strategy incurred less volatility and had a lower ending balance than the rebalancing strategy. The rebalancing strategy ended with a 75.4% allocation to equities versus a 72.4% allocation for the non-rebalancing strategy This should not be surprising since rebalancing purposely shifted the allocations back to target while not rebalancing allowed the market to determine how the portfolio’s allocation evolved.
The percentage drawdowns were the largest in the panic strategy. The panic strategy entered 2008 with the largest allocation to equities for both portfolios because it assumed an investor reverted back to his targeted allocations at the start of 2004 after being out of stocks for one year. The rebalancing strategy’s allocations were adjusted back to target in 2001 and 2006. Equity allocations under the non-rebalancing strategy were lowered in 2001 and 2002 by the bursting of the tech bubble.
The drawdowns in 2008 are the same for all three strategies in each of the 2007 start date portfolios because the financial crisis started soon after the portfolios were started.
This example clearly shows a penalty for panicking. Even if an investor has terrible timing decisions, he will do okay as long as he sticks to his allocation rather than pulling out after a loss is incurred. Incorporating a rebalancing strategy can help with the psychology.
A compromise solution for those who feel nervous about investing in an asset that may have a large potential downside is to allocate to less-volatile segments of the asset class. For equities, this would be larger-capitalization domestic stocks, and even less economically sensitive sectors such as health care and utilities. For fixed income, this would be higher credit quality and shorter duration (less interest rate sensitivity) bonds. This would preserve the allocations while reducing some of the volatility at the expense of giving up some upside when that asset class finally rebounds in price.
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