Investment Psychology & Stock Declines

A Strategy to Increase your Investment Growth without Sacrificing Security

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Quiz!

What are the benefits of high investments in a diversified stock portfolio relative to withdrawals? (Multiple answers may be correct)

  1. They help get freedom from work.
  2. They add to your cash reserves, dollar for dollar.
  3. You can count a small portion of them as part of your cash reserves.
  4. They provide a potential snowball of accelerated increase in your wealth.

A Strategy to Increase your Investment Growth without Sacrificing Security

In a perfect world, you would allocate all of your money to high growth investments, to maximize the speed of building wealth. The issue is that growth comes with volatility, and you may need your money during a big decline for your investments. Examples for needs are a loss of job, a downturn for your business, buying a house, and the biggest of all – retirement. Common solutions involve a money market account, bonds and other low-volatility investments, that come with lower growth.

Is there a better solution? It turns out that there is another solution that lessens the compromises – a low withdrawal rate from a diversified stock portfolio. A diversified stock portfolio with a low withdrawal rate of 3%-4% may grow faster than cash or bonds when subject to the same withdrawal rate.

How do you get there?

  1. Build stable reserves to survive tough situations that are out of your control.
  2. Beyond that, invest in a diversified stock portfolio.
  3. Using a likely sustainable withdrawal from the stock portfolio (typically 3%-4%), reduce your reserves by that amount, moving it into the stock portfolio. You can check periodically (e.g. quarterly), and move the money whenever your investments grow relative to your spending (through any combination of new savings and investment growth).

This strategy creates a positive snowball: The more you have in stock investments, the more you can shift from the reserves to them. This accelerates the growth of your money, which allows to move more from your reserves to stocks.

Depending on how early you start, and how flexible you are with your spending, you may be able to reach 100% allocation to stocks before retirement, allowing you to sustain it for life. This can result in some combination of:

  1. Growing security (the fixed dollar withdrawal becomes a decreasing percent from a larger pot).
  2. Higher available spending (keeping the same withdrawal rate = a higher dollar amount, as the portfolio grows).

What is the catch? There are several catches:

  1. You have to stay perfectly disciplined with your strategy. It is tempting to sell low or put new savings elsewhere, when the news is grim. This can revert the entire long-term benefit.
  2. The plan is designed to allow selling a likely sustained portion (e.g. 3%-4% per year) for spending needs. This is fine as long as the needs have nothing to do with the investment performance. You may be tempted to sell low, to invest elsewhere. This is not a spending need, and if you are tempted to do that at low points, you are better off seeking a different plan in the first place.
  3. You may underestimate the needed reserves, or simply be surprised by something unplanned. As long as it comes at a normal point for the stock portfolio, there is no problem. But, it can hurt you during deep declines. Try to be realistic.

Quiz Answer:

What are the benefits of high investments in a diversified stock portfolio relative to withdrawals? (Multiple answers may be correct)

  1. They help get freedom from work. [Correct Answer]
  2. They add to your cash reserves, dollar for dollar.
  3. You can count a small portion of them as part of your cash reserves. [Correct Answer]
  4. They provide a potential snowball of accelerated increase in your wealth. [Correct Answer]

Explanation:

  1. They can cover your expenses while not working. If they are big enough, the investment growth/income can support long periods without work.
  2. Investments can be volatile, so you cannot assume that the full amount will be available for you at any point.
  3. You can count a likely sustainable withdrawal rate (typically 3%-4%) as part of your reserves, since that amount is likely to be there for you even during deep declines. Read this month’s article to learn more.
  4. Investments tend to grow by some percent on average. As the investments grow, a fixed percentage of larger pots becomes a large amount.
Disclosures Including Backtested Performance Data

My Personal Experience with the Recency Bias

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Quiz!

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one.

My Personal Experience with the Recency Bias

What is the Recency Bias? It is making decisions based on recent events, with the expectation that they will continue.

How can the Recency Bias hurt investors? Most investments are cyclical, while the recency bias assumes no cycles. Common harm is buying high after unusual gains or selling low after unusual declines. When done repeatedly, it can lead to long-term underperformance of a simple buy-and-hold strategy.

Are there less obvious cases of Recency Bias hurting investors? Yes. Many investors are disciplined enough to hold onto their investments at low points, but they may wait for gains before investing new money. Missing a 1% or 2% gain is nearly harmless. But some investors wait for more and more evidence. Once they see (and miss) 20% or 30% gains, some wait to buy at a dip, and some wait for more evidence of gains. Only after seeing 50% to 100% gains, some feel that the gains are here to stay, and invest after missing out on huge gains. The damage is far worse than simply missing gains, leading to a negative snowball. The delayed investment hurts their personal returns, they think that their investments are worse than reality, so they stay less committed to them, hurting their returns even further, cycle after cycle.

Did I ever experience the Recency Bias? Yes & no. When trying to think about the likely returns of an investment in the next 10 years, I know that it’s likely to be different than the past 10 years, given studies of investment cycles and valuation measures. But, in anomalous times, where a cycle gets stretched longer than usual, I am tempted to temper my expectations for the next leg of the cycle. I recognize that real life works the opposite – the longer we have an anomaly, the stronger the reversal tends to be. Examples of my recency bias:

  1. When looking at the raw data, it is rational to expect the S&P 500 to lose value over the next 10 years. But the recency bias leads me to believe it may get low positive returns.
  2. When looking at the raw data, it is rational to expect non-US Value (low Price/Book) stocks to enjoy unusually high returns over the next 10 years. But I catch myself sometimes expecting only average returns.

How damaging can the Recency Bias be? The examples I gave right above are not too harmful. They don’t lead me to make decisions that are opposite of rational, so I can live with them. The harm comes from an expectation opposite of rational, that leads to decisions that are very likely to fail. Here are examples:

  1. Expecting the S&P 500 to average more than 10% per year in the next 10 years, or even 6% or 8%.
  2. Expecting low interest rates in the next few years.
  3. Expecting AI-focused companies that reached extreme valuations to significantly outperform the rest of the market in the next 10 years.

How do I avoid big harm by the Recency Bias? I base my expectations based on a combination of:

  1. Full cycle, long-term behavior.
  2. Logic.
  3. Valuations (e.g. Price/Book) today relative to typical in the past.

Quiz Answer:

Which diversified investment looks more appealing?

  1. 15% average growth per year over the past 10 years, up from a long-term average of 10% per year.
  2. 5% average growth per year over the past 10 years, down from a long-term average of 10% per year. [The Correct Answer]

Explanation: High growth diversified investments tend to be cyclical, with reversals being more common than not after 10 years.

Say that after 2 extra years, the faster growing investment continued performing better than 10% per year. Which would you choose now?

  1. The first one.
  2. The second one. [The Correct Answer]

Explanation: When above/below trend continues beyond 10 years, reversals continue to be the more common case, with greater odds and magnitude.

Read this month’s article to find out what leads people to pick the other option for both questions.

Disclosures Including Backtested Performance Data

The Latte of Investing

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Quiz!

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up.

The Latte of Investing

You may have heard how a daily $5 café latte can add up to significant money over time. Many people see it as a small daily cost that makes no difference in the big scheme. They ignore the fact that it is recurring, leading to a much bigger total. While different people value the store-bought latte to different degrees, it demonstrates how some people may overspend on small recurring items.

There is an analogy in investing. Many people get nervous about investing after declines (that involve negative news), and delay investing until things calm down. They feel that whatever gains they may miss on the small amount is dwarfed by the gains they will enjoy with the big remaining portfolio. While the logic may sound convincing at first, when repeated, the small, missed gains can add up to very big money.

What can you do? Operate consistently: invest money as soon as it is saved.

What if it’s tough to do? Recognize that if you are uncomfortable investing at the current low level, you are likely to be even less comfortable investing at an even lower level. You are very likely to wait until the news is better than today, leading to buying higher, and missing gains. Past experience of investors supports this theory – investors tend to significantly underperform the investments they use.

Initially, it may be tough to be consistent. Once you form a habit, you may enjoy the automatic action, without a need to debate often.

Quiz Answer:

Are you likely to make money on waiting to invest until conditions become better than today?

1. Yes, the negative news can lead to continued declines. Waiting allows you to buy lower.

2. No, as conditions improve, stocks tend to go up. [The Correct Answer]

Disclosures Including Backtested Performance Data

Can You Make Money Buying Stocks that Declined?

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Quiz!

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations.
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Can You Make Money Buying Stocks that Declined?

When you see your stock portfolio decline, is your instinct to double down and invest more, or sell and wait on the sidelines until the sky clears? Knowing whether a recovery at a reasonable timeframe is likely depends on multiple factors. Here are cases that could lead to disappointment:

  1. If your portfolio includes only one or a few stocks, it may never recover. Many companies go bankrupt every year.
  2. If your portfolio reached extremely high valuations, as measured by price relative to book value (or liquidation value), you could make money by holding on until past the recovery, but the recovery could be many years away.

If your portfolio is diversified and has very low valuations, you may enjoy seeing a recovery within a reasonable timeframe, making you money. This is far from guaranteed. Here are steps to increase your chances:

  1. You need a robust risk plan, that accounts for a significant amount of additional declines, with a prolonged timeframe to recovery.
  2. With the right risk plan in place, you need to be 100% committed to your plan. When additional declines occur, you are not likely to see headlines saying “don’t worry, everything will be fine, this is a temporary dip”. The headlines are likely to be between negative and terrifying. Sticking with the plan requires putting all emotions aside, focusing on your risk plan, and following it mechanically – not for the faint of heart!
  3. Buying after declines requires a great deal of humility. You may have strong gut feelings on the “obvious” next move for stocks. Avoid setting any short-term expectations – the next move is mostly influenced by information that is not available at the moment.
  4. Start by having your normal allocation. Then, given the uncertainty, it helps to have a multi-step plan, with incremental small investing with every material additional decline. Allow for more declines than you can imagine. This can empower you knowing that you are proactive with additional declines.
  5. An incremental investing plan is smart in theory, but can be tough to execute. On the way down, you are likely to feel increasingly wrong. Remember that your goal is not to call the bottom – a very tough thing to do, but to emphasize extra investing when the odds are stacked more strongly in your favor, and the risks are lower.
  6. If you don’t have long-term valuation data for your investment, one alternative is comparing the 10-year performance relative to the long run. 10-year outperformance relative to the long run could mean high valuations and high risk.
    1. For example, the S&P 500 had far above average returns in the past 10 years, leading it to reach near record valuations. Buying on the dip beyond your normal allocation in such cases can be very risky.
    2. On the other hand, Emerging Markets Value investments had unusually low returns in the past 10-years, leading to below average valuations. Buying on the dip beyond your normal allocation in such cases may be profitable, subject to all the precautions described above.

Quiz Answer:

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations. [Correct Answer]
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Explanations:

  1. While there are no guarantees, with the right plan, you can make money buying stocks that declined – read on.
  2. Diversified stock investments tend to recover after declines. As long as you hold onto the investments until they hit a bottom, fully recovered and reached new peaks, you can make money. The low valuations help avoid some of the longest declines of stocks.
  3. A careful analysis may or may not be successful at identifying the bottom. In addition, a concentrated portfolio of one stock may never recover.
  4. While diversified stock investments tend to recover after declines, if the valuations are extremely high, it may take many years to enjoy a gain.
Disclosures Including Backtested Performance Data

The Surprises & The Expected of 2020

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Quiz!

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter.
  3. It was scarier.
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual.

The Surprises & The Expected of 2020

The pandemic of 2020 was shocking to investors and humans in general. It involved substantial uncertainty, leading people to predict years of pain for stock investments. While the split between surprises & the expected will vary depending on the reader, below is my split.

Surprises:

  1. While the key actions to contain the pandemic were known early on (looking at some Asian countries), the magnitude of unwillingness to take these actions seriously in other countries was greater than I expected, leading to a much worse result than possible otherwise. While stocks recovered rapidly, they could have bottomed higher, with fewer lives lost on the way.

Expected:

  1. The decline was shorter than typical, because it didn’t come from a position of economic leverage and euphoria.
  2. When panic took hold in March, the Fed repeated its 2008 announcement, being prepared to do whatever it would take to support the economy. Other countries operated similarly.
  3. The turnaround came as soon as the level of uncertainty diminished, far before the economy improved, as typical.
  4. While the economy is still hurting badly, it started the turnaround much earlier than in prior declines, thanks to the cause being a shock and not leverage.
  5. Many people said about this decline that it’s different, and will last much longer than past declines. Fortunately, this prediction failed, as typical when made at past times of uncertainty.

The specifics of every market decline are different, creating a need to prepare for declines of varying lengths & depths, worse than we experienced before. While the specifics vary, there are some truths that follow through the cycles, especially some level of correlation between starting valuations (e.g. Price/Book) of risky assets and the severity of the decline. With the right planning, whether cash set aside or low spending relative to liquid assets, there is no need to label any case as “this time is different”. The more prepared you are, the stronger you can be going through scary times, with discipline to avoid panic selling at the depth of the decline.

Quiz Answer:

In which ways was 2020 different than other big declines (e.g. 2008 & 2000)? (There may be multiple correct answers.)

  1. It was deeper.
  2. It was shorter. [Correct Answer]
  3. It was scarier. [Correct Answer]
  4. It was longer.
  5. The turnaround came before economic improvement.
  6. The government & central bank support were bigger than usual. [Correct Answer]

Explanations:

  1. This decline was shallower than the other two declines.
  2. This decline was dramatically shorter than the other two declines.
  3. While every decline is scary, this was scarier, because we haven’t seen such a widespread pandemic in our lifetimes.
  4. This decline was dramatically shorter than the other two declines.
  5. In most declines, the turnaround comes far ahead of the economic turnaround. It comes from a combination of government & central banks (e.g. the Fed) support along with an expectation for a future turnaround.
  6. Both 2008 and 2020 saw very big government & central bank support, but this year’s support was even bigger.

See article for more explanations.

Disclosures Including Backtested Performance Data

Testing Emerging Markets Value Investments in a Simple Graph

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Quiz!

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news.
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Testing Emerging Markets Value Investments in a Simple Graph

Value stocks are priced low relative to their intrinsic value (low Price/Book, or P/B). Value investing makes logical sense: when buying cheap stocks, you can expect to enjoy higher returns. It is not only logical, but also supported by nearly 100 years of evidence. This is all nice, until you look at the past 10 years and see that value underperformed growth (high Price/Book) for the whole period. This raises the suspicion of a new normal. Maybe the entire group of companies with low prices has something wrong with them, and their value will go down over time, to justify the low price?

There is an easy test to differentiate between bad companies and cheap investments:

  1. Bad companies: The underperformance is explained by underperformance of their book values relative to the rest of the market. This is why Warren Buffett tracks the book values of his companies more than prices.
  2. Cheap investment: A lot of the underperformance of value stocks is explained by a change in their valuations (P/B) relative to the rest of the market.

As an example, here is a comparison of DFA funds, one representing overall Emerging Markets (EM), and the other representing EM Value. The graph divides the valuations (P/B) of EM by EM Value. A high value represents an increase in the price paid for all of EM relative to the price paid for EM Value stocks.

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For the year (2020), EM Value underperformed EM by about 11%, while the valuations difference increased by 15%. This means that the value companies, as measured by their book value, did 4% better than the overall market. This supports the thesis that these investments are simply cheaper, and you may reap the benefit as the valuations continue their cycle.

Quiz Answer:

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news. [Correct Answer]
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Explanations:

  1. You cannot conclude anything positive or negative from a 1 year period.
  2. See #1 above.
  3. The combination of averaging many 10-year stretches with a focus on pricing (valuations) similar to today, gives useful information.
  4. See #3 above.
  5. After a decade of unusually good returns, the risk of a weaker decade goes up, so it is not necessarily a good sign.
  6. After a decade of unusually good returns, the risk of a weaker decade goes up, but it is also not a guarantee for a bad next decade.
Disclosures Including Backtested Performance Data

A Hidden Measure of Investment Risk, Beyond Volatility

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Quiz!

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

A Hidden Measure of Investment Risk, Beyond Volatility

This article debunks a conventional wisdom that equates volatility with risk, and ignores all other factors. The following example demonstrates a problem with this narrow focus. Compare the following two situations:

  1. 1M invested in a stable investment that grows by 5% per year and never declines.
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

By focusing on volatility alone, you would conclude that the first investment is less risky. This conclusion is wrong. The lowest balance that the stable investment can reach is 1M, since it never declines. The lowest balance that the volatile investment can reach is 1.2M, since it starts with 3M and can go down by up to 60% of the peak. The first investment is riskier for two reasons: (1) it grows more slowly on average, and (2) it has a lower worst-case balance. Your risk of running out of money with this investment is greater.

Since the starting investment amounts are different in the two cases, how can this apply to the real world? An example could help:

  1. Say you have 1M invested in a stable investment.
  2. The investments grow to 1.1M through a combination of investment growth and new savings. This allows you to shift your investments towards higher expected growth along with higher volatility. Specifically, the investments can potentially decline by another 100k (10%) during declines, to get you to the prior risk during declines.
  3. You repeat the step above, leading to higher and higher expected growth, while keeping the risk level the same.
  4. Your investments reach 2.5M, and you reached an allocation for maximum potential growth, along with potential declines of up to 60%. Your risk level is still the same with the lowest balance being: 2.5M x (1 – 60%) = 1M.
  5. Your investments reach 3M, and you keep the allocation the same, since you already enjoy the maximum potential growth. But now the lowest your investments can reach is up to 3M x (1 – 60%) = 1.2M, giving you higher security, despite the much higher volatility.

Notes:

  1. Risk is determined by spending/investments, not investments alone. To account for expenses going up or down, you should track spending/investments, not just the investment balance.
  2. Another risk factor is the valuations (P/B = Price/Book, or price relative to intrinsic value or liquidation value). In diversified portfolios, high valuations lead to higher risk (greater potential decline), and lower valuations lead to lower risk (lower potential decline).
  3. Some stable investments are exposed to inflation risk, making them riskier than seems.  On the other hand, there is no guaranteed maximum decline for any investment.  It is all a matter of odds.
  4. If higher volatility leads you to panic and sell low, that is another risk factor that can take away the financial benefits described above.
  5. While income from work can be lost at any point, some jobs are much more secure than typical (e.g. doctors), and can help your risk profile.

Implications:

  1. A plan that may be risky for someone else, may be conservative for you (and vice-versa), depending on your respective ratios of expenses/investments & valuations.
  2. A plan that would have been risky for you a few years ago, may be conservative for you today (and the reverse is potentially true if your expenses grow faster than your investments).

Quiz Answer:

Which is a riskier situation?

  1. 1M invested in a stable investment that grows by 5% per year and never declines. [Correct Answer]
  2. 3M invested in a highly volatile investment that grows by an average of 8% per year and suffers significant frequent declines of up to 60% from the peak.

Explanation: See article for explanations.

Disclosures Including Backtested Performance Data

Investing in the Midst of a Pandemic

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Quiz!

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy.
  3. When stock valuations are high, and uncertainty is high.

Investing in the Midst of a Pandemic

The coronavirus pandemic brings substantial uncertainties. While the instinct is to wait for clarity before investing, the biggest returns tend to come starting at times of greatest uncertainty. This was true in past declines, and the current one is no different. On 3/23/2020, stocks hit a bottom with no clarity on the timeline for the world stopping the spread of the virus, and no clarity on how the world economy would survive social distancing. A moderate reduction of uncertainties led to phenomenal gains in stocks. As additional uncertainties get resolved, there is a chance for additional gains. This article refers to the coronavirus – as always, additional negative and positive surprises may appear, leading for ups and downs, beyond the uncertainties listed below. In addition, investors expect economic pain from the social distancing, and this may be reflected in stock prices too little or too much. Here is the timeline so far and potentially looking forward.

Past:

  1. Around the bottom, central banks and governments announced substantial support for economies, including the Federal Reserve using the term “unlimited support”.
  2. Over time, we saw the number of daily new cases in many countries level off, and in some cases, revert. This gave some comfort that with social distancing, the virus could be contained in a reasonable timeline.

Future:

  1. Additional central bank & government support until the end of the pandemic’s economic impact.
  2. Increased testing, to allow quick isolation of infected people. A lot already happened, but more is needed.
  3. Increased contact tracing, both automated and manual, to isolate people who got in contact with infected people. Automated solutions are being developed. There is currently substantial hiring for contact tracers. My understanding is that a lot more progress is needed on this item. This is a good example of creating reemployment to help with the effort to end the pandemic.
  4. Transition from level and fewer daily new cases, to a worldwide reduction in total cases, so fewer people will be able to spread the disease.
  5. A potential die-off or weakening of the virus, as eventually happens with some viruses.
  6. Treatments to reduce the severity of the disease.
  7. Widespread vaccines.

Key Point: The intuition of many investors is to wait to invest in stocks until uncertainties are removed. This leads them to invest at times with much higher risk of long-lasting declines. If you have enough resources to weather substantial declines that are always a possibility with stock investing, you may be lucky enough to invest at a time that can both help your returns as well as prepare you for future cycles.

Quiz Answer:

When are stock returns highest on average?

  1. When the world economies are strong, and investment sentiment is positive.
  2. When stock valuations are at an extreme low, reflecting a grim economy. [Correct Answer]
  3. When stock valuations are high, and uncertainty is high.

Explanation:

  1. A strong economy with positive sentiment can lead to gains for a long while, but is also reflective of peaks in stocks.
  2. When the economy is in poor shape, and valuations already reached low levels, people already sold a lot. The declines may continue for some time, but eventually a turnaround comes, and some of the strongest stock returns may begin.
  3. High uncertainty along with high stock valuations could sometimes lead to gains and sometimes losses. The high valuations sometimes mean that not enough selling was done to reflect the uncertainty.

See article above for more explanations.

Disclosures Including Backtested Performance Data

2 Hidden Risks of Selling Stocks Temporarily Now

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Quiz!

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that.
  3. No, it is risky to sell low.

2 Hidden Risks of Selling Stocks Temporarily Now

It may seem appealing to sell stocks now, and buy lower, when seeing signs of the end of the coronavirus damage. There are two hidden risks in such a strategy:

  1. Hidden Risk #1: A decline never comes, so you buy 10%+ higher. After the gain, the portfolio turns much lower. Now your investments bottom at an even lower point than without the temporary selling.
  2. Hidden Risk #2: Fast forward to the next peak. Another big decline follows. During the entire decline – from peak to bottom – you have less money.

A variation is to sell stocks now, and wait to buy until we are completely done with the coronavirus impact. This is likely to eliminate Hidden Risk #1, but it makes Hidden Risk #2 far worse. By the time we are completely done with the coronavirus impact, your investments could potentially be 100%+ higher. The impact on all future declines can be devastating.

You may be desperate for some relief from the stress of staying invested at a low point, and are still tempted to sell. The relief is an illusion:

  1. If you are stressed now, imagine the stress after selling, reinvesting higher and then going to the bottom with less money.
  2. You may be tempted to sell and not buy until far into the future. As strong as it is at relieving the current stress, it is devastating at the depths of the next decline – lowering its bottom dramatically.

By holding onto your investments, you ultimately get the portfolio returns. While stocks may face long periods with poor returns, it is much better than risking making future declines deeper and longer.

Mirroring the risks above, if you still have income and are able to invest at today’s low levels, you can boost your financial security in future declines for the rest of your life.

Quiz Answer:

During a big decline, is selling stocks until the storm passes conservative?

  1. Yes.
  2. It is conservative at the moment, and likely riskier beyond that. [Correct Answer]
  3. No, it is risky to sell low.

Explanation: See this month’s article.Disclosures Including Backtested Performance Data

5 Rules of Thumb to Avoid Making a Painful Investment Change

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Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the MSCI Emerging Markets Index grew by a mere 4.1% per year in the past 10 years, compared to 10.5% nearly 32-year average. Returns above the 10.5% average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.

Disclosures Including Backtested Performance Data