Market Insanity: to Sell or not to Sell

I vowed after turning thirty to never ride roller coasters again.  My stomach can't seem to take it anymore.  I'm getting that same sinking feeling from the financial markets lately.  The last several months have been quite trying for long term investors.  Economic factors beyond our control have wreaked havoc on the global economy, and watching from the sidelines has been difficult to endure.  So, what should you do as an investor?  Should you hold, should you run for the exits? Converting to cash, while tempting and psychologically satisfying, can actually have an adverse effect on your long term wealth and could prove exactly the wrong thing to do right now.

It's impossible to dodge the recent chatter, as current stock market volatility and looming recession fears has everyone talking.  They all have something to add about the economic environment.  The global credit crunch and slumping real estate market have had a far reaching impact on the global markets.  Clearly, none of us enjoy seeing the stock market indexes plummet (except for investors trying to short the market).  But, when stocks slide south, "panic and sell" is not the right strategy.  In fact, it's completely irrational.  

Investing in stocks is not a risk free process. If you want a "worry free" T-bill experience, then you deserve to get T-bill returns.  As investors, we get compensated for taking these risks and we should expect the volatility associated with such risks.  Let's face it, it's impossible for stocks to always go up and stay up, as they did in the late 90's and for the last several years.  

Short term market gyrations are just part of the deal and markets usually snap back after some period of time.  Yet, it is impossible to ascertain exactly when that recovery might take place.  If you cash out when the markets sink and sit on the sidelines for the "right time" to get back in, odds are you will likely miss out on critical potential growth.   The fact is, large market gains can come in quick and unpredictable spurts.  Missing just a few days of strong market returns will substantially erode your long term performance.  

The chart below depicts the performance of the S&P 500 from 1970 to 2006.  As you can see, the returns for the S&P for the extended period were 11.23%. Yet, during that time frame the index experienced eight years of negative returns, at various times.  The worst consecutive performance periods were 1) 1973 to 1974 when the index lost -14.67% and -26.46%, respectively and 2) 2000 to 2002 when the S&P lost -9.10%, -11.89% and -22.10%, respectively.  A lot of investors bailed out, opting for the safety of cash in a very volatile and uncertain time.  But those that endured the uncertainty were handsomely compensated.  Let's refer back to the S&P returns for the 1970-2006 period.  An investor fully invested during whole time frame yielded 11.23%.  But, say you had bailed out then jumped back in after missing five days of good returns, you would have garnered only 10.34%.  If you missed the best 15 days, you would have earned a crummy 8.97%, a difference of over 2% in annualized returns.  Compound that over 25 years and you get a big wad of money in
your pocket if you stayed the course!   Get the picture?

(Source: Dimensional Fund Advisors)


Simply stated, there is no possible way that you can foretell these market events.  Daily market returns are completely random.  The worst market day in our recent history was October 19th, 1987 (Black Monday).  If you were an investor back then who panicked and retreated to cash, you would have missed the best single day following that event on October 21st, just two days later.

Repeat after me..."market risk can never be eliminated", but a globally diversified portfolio can effectively chip away at the risks that can be diminished.  The most important defense you have right now, and always, is a sound portfolio design and patience.  Emotions have no room in investing.  If you have a properly structured portfolio, market corrections and economic disruptions become irrelevant over your investment lifetime. The idea is that you are in this for the long haul, and your needs for cash or portfolio preservation can be effectively captured with a healthy allocation to high quality, short term bonds.  However, if the market volatility is keeping you up at night, then you are in the wrong portfolio.  Periods of market uncertainty provide the best scenario to gauge your true risk tolerance, which I might add, is very difficult to measure in advance.  If you can't take the heat, I suggest that you re-asses your investment structure and scale back on the risk.

So, let's keep things in perspective.  The US economy has gone through and will forever endure various expansionary and recessionary cycles.  That is how economies ebb and flow.  There are still many economic unknowns for the market to weather, we can expect that for sure.  But, while it feels like the world might be crumbling around us remember this, Capitalism is alive and well and will continue to persist.  Remember too that risk is natural part of investing and market corrections are all part of normal market cycles.  Without either, we would not be adequately compensated for our investments.  For several consecutive years now, we have all enjoyed the upside of that same risk.  We must take the bad with the good.  

In summary, short term performance can really test your commitment to your investment plan. But, it's in times like this that investors have to keep an even keel. Investing in equities will reward investors who keep a long term outlook, and bailing out when the going gets tough is simply the worst thing you could do to yourself .