Don’t Miss Out on Market Rebounds
One of the most common and costly mistakes made by investors and professionals alike is making panic-related sell decisions. Getting out of the market based on market noise and perceived risks often leads to significant underperformance because it requires impeccable timing with respect to both exiting and reinvesting into the market.
This is further complicated by the fact that much of the market’s gains are realized in a small number of days.
Trying to avoid the inevitable market movements causes investors to miss out on the best daily returns because they often occur in the days following periods of market declines and volatility. These "best day" misses compound over the years and can amount to a significant reduction in long horizon wealth.
IMPACT OF MISSING THE BEST DAYS IN THE STOCK MARKET (1974 - 2015)
Source: Fama & French daily market returns
To illustrate, consider stock market returns from 1974 through 2015. This period encompasses some very big market movements, including 1987’s Black Monday (down 22% in one day!), 2000-2002 (down 46%), and 2007-2009 (down 52%).
But the investor that stays fully invested over this period benefitted by reaping an annual compound return of 11.0% and ends up with $800,000 on an initial $10,000 investment. On the other hand, missing just the three best days each year during that period actually produces a negative 1.2% annual compound return, decreasing the initial investment to a final value of $6,000.
AthenaInvest believes that building wealth is a long-term endeavor and requires time as well as discipline, specifically the ability to manage one’s emotions. The equity market pays investors a premium over cash and bonds precisely because it requires investors to endure the swings in the market. Selling to avoid the downturns more often than not means you’ll miss the upside moves that lead to long-term gains.
From the Behavioral Viewpoint
What is going on?
- Constant market chatter combined with large market movements trigger our fight-or-flight emotional responses and what is known as loss aversion (the preference of avoiding losses to acquiring gains) and we take action to avoid perceived risk.
- In a down market, we often assume, in error, that we are missing something the crowd knows. Herding, the instinct that others know something we don’t and we should move with them, kicks in and motivates us to take action.
- We overestimate our abilities to determine both the best time to exit and to move back into the market while underestimating the randomness of short-term returns. This overconfidence bias results in emotional selling, locking in losses while missing subsequent strong returns from a market upturn.
- In highly emotional markets, our reaction is to simply get out of the market and wait until things calm down. Unfortunately, most market activity is random and we often have no reliable way of determining when the market has “calmed down” and when it’s “safe” to get back into the market.
What can we do?
- The key to ignoring the herd is to have a disciplined strategy that keeps your emotions in check. Like many other areas in life, good planning, including having a strategic asset allocation model and pre-determined times for rebalancing and investment actions, can lead to better results. A professional financial advisor who has lived through many market environments can help an investor stick to his or her long-term goals and act as a trusted resource and coach.
- If you feel compelled to act upon changing market conditions, hire a portfolio manager that specializes in managing market conditions and has a rigorous and disciplined approach. Allocate a predetermined amount to the manager and stick with them through several market cycles.
- If the emotions are still too overwhelming, limit your short-term actions and consider selling a smaller portion, such as 20% to 30% of your position. You will gain a sense of doing something while at the same time not overreacting and retaining some opportunity to benefit from the markets rebound.
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IMPORTANT INFORMATION AND DISCLOSURES
The information provided here is for general informational purposes only and should not be considered an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. It should not be assumed that recommendations of AthenaInvest made herein or in the future will be profitable or will equal the past performance records of any AthenaInvest investment strategy or product. There can be no assurance that future recommendations will achieve comparable results. The author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions. AthenaInvest disclaims any responsibility to update such views. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of AthenaInvest.
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