Downturns in the financial markets are an uncomfortable part of investing. It’s best to take steps to plan ahead of a market downturn, but what do you do during sales are also key. Especially for equity investors, loss aversion is completely unrealistic. But sometimes individuals make decisions that create preventable financial losses. Here are three ways to reduce the risk of incurring unnecessary, self-inflicted losses in a down market.
Individual stocks ≠ the stock market
You’ve heard it before: past performance does not indicate future results. It’s not just legal – it’s real – and the chart below shows why. this point. After years of strong performance…
…great drawdowns have affected both new public companies and qualified stocks. Compare these drawdowns to the Russell 3000 and suddenly the stock market appearance to bad.¹
For individual stocks, drawdowns like this are not uncommon. According to JP Morgan, between 1980 – 2020, about 45% of stocks ever in the Russell 3000 fell 70% or more from a previous peak and never recovered. Almost a coin toss.
Make no mistake, investing in a single company (perhaps from employer stock options) can lead to huge gains, far beyond a diversified index. The issue is when investors don’t properly measure their risk, don’t understand exposure, or don’t know when to take profits.
Checking your accounts can do more harm than good
One way investors incur unnecessary losses is to check their portfolio during a market downturn. To illustrate, the chart below plots the total year return for the S&P 500. The purple line shows daily gains and losses while the orange line reports monthly.
Both have the same net result.
But if you were checking your account every day there would be a full more ups and downs to deal with. Wild swings in the market will stress you out at best, and at worst, encourage you to make hasty investment choices that could result in self-imposed losses.
So if you’re not planning to change, what’s the point? If there is a reason to trade, make sure that the inclination does not influence the decision.
In search of the market
It can be tempting to make changes to your portfolio after recent events. Looking at various equity indices for company size and factors, there is little correlation between the best or worst performers over the past month or year over longer time periods. In fact, recently, the result has been reversed.
The monthly return of the small cap, high dividend, and defensive, and value sectors is impressive. But going seven years, these indices are the worst. Does that mean you shouldn’t have investments with these characteristics in your portfolio? No! It simply shows the importance of diversification. Markets are cyclical.
If you are looking at your account daily, it is tempting to sell the losers and chase the winners. This can have lasting implications. These charts also show the downside of tax loss harvesting. Harvesting losses for tax purposes alone may have wider implications because of the wash sale rules.
If you sell an investment for a loss, you cannot buy back the site (or one that is substantially similar) for 30 days. So either you buy something you don’t like that much or you stay in cash. The market can move significantly during this time – the above four indices have gains of over 10% per month.
This is not an anomaly, either. According to Bespoke Investment Group, since 1928, the S&P 500 has returned an average of 15.2% in the first month of a bull market. Over the first 3 months, the average gain increases to 31.6%. What the market will do coming out of the 2022 bear market is anyone’s guess, but historically, markets move quickly, and the best market days often come within a week or two of each other. Worst.
Money line! Market changes can bring opportunities
Market conditions may not be changing all sad story. Rising interest rates are bad news for stocks, bonds and home buyers. But, for cash-strapped individuals, it’s a big win. One-year Treasuries are now yielding 4.75%…compared to .17% a year ago (November 2021). That’s a 2,700% increase! Investors can create a Treasury ladder or buy a longer maturity to lock in the return.
Even high yield savings accounts have a good return on cash. There’s no reason to park a lot of money in a 0% checking account without earning any interest when you can enjoy a safe 3% APY in the right savings account.
However, it does not suggest individuals to dump their portfolio and buy Treasuries! But for some investors, returns are attractive enough that Funds should be part of the conversation when considering an allocation for a new cash investment.
It also highlights the nuances in investing and why many things are not black and white. Don’t check your account daily doesn’t mean never check. And a passive buy-and-hold strategy should not ignore rebalancing needs, the right tax-loss harvesting opportunity, or periodic fund evaluations.
In down markets, people tend to want to act. To do something to stop the losses. Acting on this urge is often (though not always!) a wise decision. This is perhaps also the most common way for investors who manage their own portfolios to prevent financial losses.
¹ Total return percent high, Russell 3000 drag down about -22% through 11/3/2022. The Russell 3000 represents about 97% of the US equity market.