From the highs reached in early spring, the S&P 500 is now down roughly 12%. International stocks (MSCI EAFE) and small caps (Russell 2000) are down even more, as both have fallen roughly 17% from their 52-week highs.
These types of losses are the cost of doing business in the stock market, but drawdowns always keep things interesting because emotions start to run higher than usual. People start to pay attention to their portfolios when losses begin to pile up.
At this point, it’s easy to sell stocks because for many selling is the easy part of the equation. There’s always a good reason to sell. Studies show that most investors are actually able to diligently follow an established set of rules when making the sell decision. It’s getting back in and buying after the fact that becomes really difficult because cash quickly turns into an investor’s security blanket.
One of the biggest reasons for this is because people’s perception of risk is constantly changing. Wes Gray from Alpha Architect covered the idea behind this in a recent post:
Consider the concept of dynamic risk aversion, which is the idea that human beings don’t stick to a set risk/reward behavior—their appetite for risk can change depending on their recent experience… As market prices drop below the twenty percent threshold, an economist assumes that the new price is a bargain. Expected returns have gone up after prices have moved down, while volatility and risk aversion are assumed to be relatively constant…
But this doesn’t happen. Stocks can—and have—gone down over fifty percent, and these movements are much more volatile than the underlying dividends and cash flows of the stocks they represent! Remember 2008/2009? How many investors swooped in to buy value versus threw the baby out with the bathwater and kept selling? …
One approach to understanding this puzzle is by challenging the assumption that investors maintain a constant aversion to risk. Consider the possibility that investors change their view on risk after a steep drawdown (i.e., they just lived through an earthquake). Even though expected returns go up dramatically, risk aversion shoots up dramatically as well.
I’m not saying the pain is over in the stock market and the coast is clear. That’s certainly a possibility, but volatility and losses have a tendency to lead to more volatility and losses in something of a self-fulfilling prophecy. Our ever-changing perception of risk shows that stocks can always fall further than most would assume to be rational (same thing works on the upside as well).
During a market correction you’ll hear plenty of market aphorisms or advice being thrown around:
Cut your losses quickly.
Sell the rips and buy the dips.
Don’t try to catch a falling knife.
Buy when there’s blood in the streets.
Be greedy when others are fearful.
These sayings all make for nice soundbites. Some may even turn out to be correct depending on how things play out. But they don’t help people make actual portfolio decisions. There’s much more that goes into a legitimate investment process than catch phrases.
The way I see it there are a few different different options investors have in order to deal with market corrections.
- Implement a strategic, diversified asset allocation approach that balances your ability, willingness and need to take risk with your long-term goals and time horizon.
- Implement a disciplined, rules-based approach to buy and sell at pre-determined levels or triggers.
- Follow the investment process you have set up in advance that takes into account your personality, knowledge of the markets and ability to stick with the plan.
- Panic and sell after everyone else has.
- Don’t have a plan in place and just wing it.
- Listen to whatever billionaire hedge fund manager is giving their latest macro outlook and follow what they say is going to happen.
Options 4-6 are usually what actually ends up happening with many investors as they allow their emotions to dictate their portfolio decisions in heat of the moment. Options 1-3 are much more reasonable and make a lot of sense. None of them are perfect, but the goal when creating a portfolio is not to be perfect. The goal should be to survive these types of markets with minimal mistakes and unforced errors.
Here’s a video I did with CNBC last week with more on this topic:
Keep Cool During Correction (CNBC)
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