Panic and sell, now what?

By LARRY SWEDROE

The academic literature on investing is filled with hundreds of anomalies. My own view is that the greatest anomaly of them all is that while investors idolise Warren Buffett, the “Oracle of Omaha”, so many not only tend to ignore his advice but often do the exact opposite. Consider the following advice he has offered on trying to time the market:

– In his 1991 annual letter to shareholders, Buffett advised: “ We continue to make more money when snoring than when active.” He added: “Our stay-put behaviour reflects our view that the stock market serves as a relocation centre at which money is moved from the active to the patient.”

– In his 1996 annual letter to shareholders, he advised: “Inactivity strikes us as intelligent behaviour.”

– In his 1998 annual letter to shareholders he advised: “Our favourite holding period is forever.”

– In a June 25, 1999, interview with Business Week, he advised: “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

– In his 2013 annual letter to shareholders, he advised: “Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important.”

– In another often-repeated quote, he advised: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”

The bear market sparked by the COVID-19 crisis presented investors with a test of the ability to control their temperament, which Buffett advised was the key to successful investing. On February 19, 2020, the S&P 500 closed at 3,386. Just 23 trading days later, on March 23, it closed at 2,237, a drop of 34 percent — the sharpest drawdown in history over such a short period. How did investors fare? Did they control their temperament?

While we don’t know how all investors did, we do know a large percentage failed the test.

One of the biggest problems facing these investors who ignored Buffett’s advice and engaged in panicked selling is what they do next. With yields at historically low levels, most will be unable to achieve their financial goals sitting totally in cash or safe bonds. That means at some point they will have to decide when it’s safe to get back into stocks. It is also important to remember that the problem with market timing is that you have to be right twice — when to get out and when to get back in.

Whenever I have discussions with investors who are tempted by the latest crisis to abandon their well-thought-out plan, I first remind them about Buffett’s sage advice. Then I use the following tale to hopefully lead them to the right strategy of adhering to their plan — one that incorporates the virtual certainty that they will experience several severe bear markets in their lifetime. Remember, this bear market is the third in just the last 20 years with a loss of at least 34 percent.

If I sell now, then what?

If you go to the beach to ride the waves and you want to know if it’s safe, you simply look to the lifeguard stand. If the flag is green, it’s safe. If it’s red, the ride might be fun, but it’s too dangerous to take a chance. For many investors today, the market looks too dangerous. So they don’t want to buy, or they decide to sell. Here’s the problem: While the surfer knows that it’s safe to go into the water when he sees the green flag, there is never a green flag to let the investor know that it’s safe to invest.

You might think that is the case (as many investors did in the late 1990s), but it never is. Recall the litany of problems the markets faced from March 9, 2009 (when the bear market ended), all the way through 2019. There was never a green flag; it was red the entire time. And for much of that period (from 2013 onward), highly regarded market gurus such as Jeremy Grantham warned that the market was massively overvalued. Yet, the market ignored those warnings and provided returns well above the historical average. So, once you decide to sell, you are virtually doomed to fail as you wait for the green flag. Even worse is what happened to some investors who only thought they saw a green flag.

The example of 2007-2009

Consider an investor who, after watching the S&P 500 Index crash from about 1,450 in February 2007 all the way to 752 on November 20, 2008, finally throws in the towel. He cannot take the losses any longer. He is worn out by the wave of bad news. So he decides to sell. However, he knows there is a problem. With interest rates at their then-current level, there was no way he could achieve his financial goals without taking risks. And he certainly does not want to buy riskier fixed-income investments (such as high-yield corporate bonds, preferred stocks or emerging market bonds), having watched how poorly they were performing. The mistake of confusing yield with return was one he was not going to make. Thus, he designs a strategy to get back in. He will wait until the next year to see if the market recovers. By January 6, 2009, the S&P 500 had risen almost 25 percent, to 935 (a very similar experience to what happened between March 23, 2020, and the end of May). Of course, he had missed that rally while he waited for the green flag. But now he feels it’s once again safe to buy.

Unfortunately, by March 9, 2009, the market had dropped all the way back to 677. So now he sells again. How likely do you think it is that he would ever find the courage to buy again? That is the essence of the problem.

Large drawdowns are very rare

Here’s some further evidence that might help you avoid panicked selling. Prior to 2020, there had been only two months in the last 78 years when the S&P 500 Index fell more than 15 percent: October 1987’s loss of 21.5 percent and October 2008’s loss of 16.8 percent. How did the market perform after those losses? While November 1987 tested investors with a further loss of 8.2 percent, the following 12-month return (November through October) was 14.7 percent. And while November 2008 also tested investors with a further loss of 7.2 percent, the following 12-month return was 9.8 percent.

Prior to 2020, over the last 80 years, we had experienced four quarters in which the S&P 500 lost more than the 20 percent: the four quarters ending September 1974 (-25.2 percent), December 1987 (-22.6 percent), December 2008 (-21.9 percent) and June 1962 (-20.6 percent). Over the next 12 months, returns ranged from 17 percent to 38 percent (averaging 28 percent); over the next 36 months, returns ranged from 49 percent to 73 percent (averaging 61 percent); and over the next 60 months, returns ranged from 95 percent to 128 percent (averaging 112 percent).

On the other hand, it’s important to remember that just because the market rallied 36 percent from the bottom on March 23 through the end of May, it doesn’t mean it is safe to “go into the water”. As noted above, investors who thought the 25 percent post-Thanksgiving rally in 2008 meant the all clear signal was given saw the market fall 28 percent again, before it began its rally on March 9, 2009.

FOUR LESSONS TO LEARN

First, it’s important to understand that bear markets are a feature of the stock market.

Without them, there would be no risk and therefore no equity risk premium. As investors, we would not like that. If we were to look back at every other market decline, we would see there were investors who thought the only light at the end of the tunnel was from a truck coming the other way. In each instance, it turned out that wasn’t the case. And it likely isn’t the case now, either. In other words, every past decline looks like an opportunity; every current decline feels like risk.

When the stock market is meeting our best expectations, thinking about the market’s inevitable up and down cycles and the benefits of a disciplined approach sounds reasonable, even easy. Yet, when the market goes down, it often feels different, maybe difficult. That is explained by the tug of war between our emotions and our reasoning. Which side wins? French philosopher Blaise Pascal declared: “All of our reasoning ends in surrender to feeling.” One of the most important roles played by financial advisers is to prove Pascal wrong!

That is why it’s important to write down your reasoning in an investment policy statement (IPS), tied to your specific goals. That way, when emotions grow strong and threaten to overrule reason, reason can prevail. Reason can remind us that this current market correction was expected (you just did not know when), and your financial plan is designed with this in mind.

Second, your investment strategy should be based on evidence, data and logic.

Thus, you should not be swayed to change your strategy unless you are convinced the underlying assumptions on which your strategy was based have changed. There is nothing in today’s environment that should lead you to conclude your assumptions no longer hold.

Third, there are always things to worry about.

It’s why, during bull markets, stocks are said to “climb a wall of worry”. Thus, it’s important to remember that while you might be worried about such issues as still-high U.S. equity valuations (the Shiller CAPE 10 is about 29), finding a cure and/or vaccine for COVID-19, the rapidly increasing debt-to-GDP ratio, the rapidly increasing money supply, and the potential of a major trade war with China, you can be certain that the sophisticated institutional investors now accounting for about 90 percent or more of trading volume (and thus setting prices) are also well aware of those issues. Thus, these risks are already incorporated into prices. That means that unless the outcomes are worse than expected, markets should not fall further. Remember, it doesn’t matter whether news is good or bad, only whether it is better or worse than already expected.

Fourth, don’t make the mistake of confusing strategy with outcome.

Fooled by Randomness author Nassim Nicholas Taleb had the following to say on confusing strategy with outcome: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Unfortunately, in investing, predicting results is notoriously difficult. Thus, a strategy should be judged in terms of its quality and prudence before, not after, its outcome is known.

Simple, but not easy

Returning to the advice offered by Buffett, he famously stated that investing is simple, but not easy. The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its envelope until it reaches its destination. Investors should stick to their asset allocation plan, as laid out in their IPS, until they reach their financial goals. This understanding allowed Buffett to ignore all the critics who criticised him for his “outdated” value strategy during the dot-com boom of the late 1990s, when growth stocks far outperformed value stocks. He didn’t abandon his beliefs then (and was rewarded over the next decade when value dramatically outperformed), and I’m confident he hasn’t abandoned them now.

The reason investing is not easy is that it is difficult for most investors to control their emotions — emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weaker stomachs and without investment plans to those with stronger stomachs and well-thought-out plans — with the anticipation of bear markets built in — as well as the discipline to adhere to those plans. Are you following Buffett’s advice?