It’s a fact that people make decisions differently when calm and collected (academics call this a “cold state”) compared to when we’re reacting to an emotional situation. You don’t need to be a behavioral economist to guess which state of mind results in better decisions. So it’s smart to discuss those situations as far ahead of time as possible, to set up a plan you can stick to.
It’s time to have one of those discussions.
Our customers have been investing with us since late 2010, and so have witnessed a strong positive market. Since the 2008-2009 financial crisis, global financial markets have more than recovered and have been on a tear, returning more than 115% cumulatively in a Betterment 70% stock portfolio since January 2009.¹ While this has caused increasing speculation of an imminent drawdown, the fact is that without a crystal ball, efforts to call a top or bottom are just as likely to hurt your returns as help them.
Looking back, there have been multiple false ends to the rally through this period. Some of the drawdowns have been as much as 18% in a Betterment portfolio with an allocation of 70% stocks. However, it’s important to know that those who reacted to these short-term drawdowns would be significantly worse off now than investors who stayed invested throughout.
I don’t have crystal ball. Nobody does. But I do believe there will be a significant market drawdown sometime in the future—that’s part of investing and bearing risk.
However, it’s helpful to acknowledge today that you will go through that stressful situation tomorrow or in seven—or 17—years from now. This preparation will help you be less stressed, perform better and give you the ability to tune out the short-term noise in the future. Remember, one broken egg doesn’t ruin the whole dozen. On average you are better off staying invested at the correct risk level for your investment horizons than trying to maneuver and avoid a temporary market loss. The key is having a good long-term plan and sticking to it.
Try the feeling on for size
I want you to plan for this event in advance and not react when it happens. Spend some time imagining how this would feel:
It’s Friday morning, and in the past week the S&P500 has fallen 20%. When you hear the morning news, it’s nonstop about how badly the markets are doing. The paper is comparing the drawdown to 2008. Frankly, it’s scary as hell, and when you look at your investments they are down 18% to where they were earlier that week.
What will you do?
(A) Increase your stock allocation or throw money into the market hoping to get some bargain prices.
(B) Nothing. Time to go work and conduct business as usual.
(C) Decrease your stock allocation to all cash.
I hope it’s clear that our advice will be (B), at least as long as you are already at your correct stock allocation. Reacting to market drawdowns by moving to cash is like swerving your car after you have hit the pothole. It won’t help you fix the damage that is already done, and it’s likely to cause a new accident or problem in the future.
That said, there are beneficial steps you can take in response to a market downturn—and some steps Betterment automatically does for you.
Automated benefits during a downturn
After or during a drawdown, Betterment will automatically:
- Tax loss harvest—this can help you capture any losses in your portfolio and use them to lower your tax bill.²
- Rebalance each of your goals to maintain your selected allocation level and/or buy depreciated assets at a lower price.
- Alert you if you go off track for reaching your goals. We may suggest either a one-time deposit or a slightly higher auto deposit amount to make up for any market losses. However, it’s important to note that most people with longer-term goals will not fall off track.
Keep calm and carry on
Here are some actions you can consider during a downturn:
- Revisit your goals and plans. Now, when the market has been doing well, is a great time to check on your Safety Net goal. Is it fully funded and at the proper allocation level? Have any of your goals gone off track and need a top-up?
- Rebalance opportunistically. Market drawdowns are one of the most frequent causes of rebalances, as the losing asset become underweight relative to the stable assets. Rebalances are an automatic and systematic way to buy lower and sell higher. However, in taxable accounts, selling can trigger taxes, even if the asset is substantially below its all-time high. Rest assured, Betterment will never cause short-term capital gains tax to rebalance your portfolio. But you can additionally minimize long-term capital gains by making opportunistic rebalance deposits. Under the Portfolio page of your account, you can see the minimum deposit necessary to avoid a sell-based rebalance.
- Liquidate your legacy losers. The most common barrier to consolidating your investments is capital gains tax. Take advantage of a short-term market drawdown and let go of an under-performing mutual fund, or diversify away from a single stock position. What can you do today? Prepare a short list of investments you would like to liquidate, and the price at which you will give them the pink-slip. Our tax-switch calculator can help with that.
- If you can’t stand the heat… turn it down: While the best investment strategy is typically to stay invested, some people could find the stress simply to be too much. If you think you might make an extreme decision—such as moving to 100% bonds—if the drawdown continues, then it’s ok to reduce your risk temporarily. Adjust from 90% stocks to 60% stocks, for example, for a 60-day period. Make sure you set a reminder to revisit your portfolio at that point. While we don’t believe it will improve your performance from a ‘cold’ view, it means you’ll be less likely to make an emotional decision, and you’ll have a higher return per nights lost sleep.
- Take a vacation from your portfolio: My own research has shown that people are more likely to monitor portfolios during volatile periods. The only problem is that the more you monitor, the riskier your portfolio will seem to you. A better strategy is to login less during volatile periods—a strategy successful investors with higher emotional follow. Sometimes it pays to be the ostrich.
- Get a second opinion: Have a friend with a cool head? Sure you do—or give us a call. While Betterment is all about efficiency, we know there’s no replacement for a human conversation. And we love talking to you guys. Seriously.
The core reason investing has higher expected returns compared to a cash account is that it is the compensation for bearing risk. Your “job” as an investor is one of the easiest ones in the world, at least physically—you must do nothing. That said, it’s not emotionally easy. It’s very uncomfortable to not react, even when it’s the right choice. So choose your reaction with a calm heart and a clear mind.
²Tax loss harvesting will only occur for qualified customers who have turned on the service for their account. Learn more about our tax loss harvesting.