How Disciplined Will You Be in the Next Downturn?
Every investor should have a fire-drilled plan for the next market drop because anticipating your own behavior is part of what makes you a better investor.
Market drops and losses are an expected part of investing. Accepting risk is how you earn returns.
Your success as an investor depends on how you respond to losses.
Plan ahead for what you’ll do during a market drop to help ensure you don’t make any irrational mistakes.
I can’t take any further losses.
I’m just not comfortable with losing 8% of my money in one year.
I’ll start thinking about more aggressive investments when the dust settles.
The stock market is pretty rough right now. If that continues, I don’t want any part of it.
I know I shouldn’t time the market, but it’s now up 3x and I can just see it reversing course soon!
These are just a few paraphrased notes from Betterment customers who reduced their stock allocation in January or February 2016. From Nov. 1, 2015 to Feb. 11, 2016, the global stock market (ACWI) fell about 15%.
And, of course, markets then rallied 31% to today, September 2017. Looking back from February 2017, a stay-the-course investor tracking the index would be up about 20% cumulatively.
A reactive investor, who sold in February then re-bought when markets recovered in July, would be up only 4%.
Source: data from Xignite, total returns data for ACWI ETF representing global stock markets.
We published research showing that the more a customer changes their allocations, the worse their performance is. On average, investor returns dropped about 0.20% per year for each allocation change the customer made. This means if you change your allocation three times per year, you could underperform by about 0.60%.
That’s more than twice the annual cost of Betterment’s advice and portfolio management.
One study by Vanguard of 58,000 of their IRA account holders from 2008 to 2012 found that those who reacted to the crisis had significantly worse performance than those who stayed the course, giving up about 1% a year. When you consider that a reasonable rate of return for global stock markets is about 6%, that could mean giving up about 17% of your expected return.
How can you ensure that you won’t succumb to the same fears and anxieties the next time a market drop hits?
My recommendation has just three simple steps:
- Arrange your finances.
- Write out a downturn plan.
- Stick to it.
Arrange your finances.
Properly arranged finances make it much easier to glide through a rough market by buffering and hedging your overall downside exposure. Here are four major steps to getting your finances in order.
1. Have an emergency fund.
An emergency fund is usually one of the highest priority goals we recommend customers have, and we believe it should be invested conservatively. A bond-heavy portfolio does a better job than cash at preserving the real value of your wealth.
One reason it’s important to have an emergency fund is because it gives you peace of mind when longer term, higher risk portfolios are more affected by a market drop. If you need to make a withdrawal from your emergency fund, you’ll be able to access it since it’s invested conservatively and is less likely to experience an extreme loss than a fund invested in a more aggressive allocation.
2. Earmark your money for future expenditures.
It’s also smart to earmark your money for future spending. At Betterment, we call this setting a goal.
Setting up goals helps to make sure you have money when you need it, aligning our investing advice to your life needs.
From existing research on goal-based wealth management and internal research on Betterment customers, I believe investors who use specific and highly personal goals could not only save more, but might also earn higher returns.
3. Don’t take on more risk than necessary given your time horizon.
It’s easy to get excited when markets have gone up and increase your stock allocation to try and benefit from it. While it’s ok to deviate within a range, we generally don’t recommend going outside our recommended ranges.
Our stock allocation advice is based on your goal type and how long you’re investing for. We take into account the total cumulative returns over that period and figure out an optimal amount of risk for you to take on. You generally shouldn’t take on significantly more risk than we recommend. It exposes you to drawdowns that your portfolio may not have time to recover from.
4. Don’t invest in a portfolio that might keep you up at night.
Your emotional time horizon is likely much shorter than the goal term. That’s why, when setting your allocation, we show you a range of one-year performance you can expect from that portfolio.
Have an honest chat with yourself about how much of a loss would be too much to bear.
Imagine you had invested $100,000 a few years ago, and today you logged in to see your portfolio was down to $90,000, a -10% loss. Would that be too much?
How about $70,000, a -30% loss? How about $44,000, a -56% loss? That’s how much a 90% Betterment portfolio lost in 2008-2009. For a 90% stock portfolio, up to -27% drop over any one-year period wouldn’t be unusual.
You should choose a stock allocation that you could stay invested in, even during a down market. So if the “poor” market performance would be too painful for you, feel free to take on less risk. You’ll have to save a bit more, but you’ll be able to sleep at night.
Write out your plan now.
Prioritize your goals. In a market drop, most of your goals will experience a loss. That might mean shifting balances between them, or waiting longer to achieve some after the market rises again. Know ahead of time what goals you’ll prioritize and whether or not you’ll need to move money from lower priority goals to higher ones.
Have an anti-monitoring strategy too. At some point, the stress of seeing losses increases the chance that you’ll do something impulsive. Rather than test your fortitude and willpower, give yourself a break from the stress. If the news is bad, you can always choose to not log into your account.
What can you do during a market drop?
Liquidate legacy losers.
The most common barrier to consolidating your taxable investments is capital gains tax. Take advantage of a short-term market drawdown and let go of a high cost 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 also help with that.
Do less than you want to.
While the best investment strategy is typically to stay invested, some people could find the stress simply to be too much to bear. 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 may mean you’ll be less likely to make an emotional decision and have a higher return per nights lost in 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 emotions do follow. Sometimes, it pays to be the ostrich.
The figures contained in this article have been obtained from third party sources, and their accuracy and completeness are not guaranteed by Betterment. All performance data quoted represents past performance, and past performance is not indicative of future returns. The conclusions drawn in this article should not be construed as advice meeting the particular investment needs of any investor, and they are not intended to serve as the primary basis for financial planning or investment decisions. This material has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument.
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