Most people are familiar with the old adage, "buy low, sell high."
Yet, once again, many investors seem to be doing the exact opposite.
From today's Wall Street Journal: "Investors world-wide have funneled more than $900 billion into U.S. domesticated mutual and exchange-traded funds, on a net basis, during the first half of the year...That is a record in data going back to 1992 ... Companies in the S&P 500 traded recently at around 28 times their last 12 months of earnings (WSJ 7/26/2021).
In other words, investors are buying now that prices are high. Prices are not just high, they are at their highest level in decades! And what were they doing back in April and May 2020, at what would have been the ideal time to be buying? You guessed it; investors were selling.
Why do many investors do the opposite of what they believe to be true?
Because there is often a disconnect between what we know and how we behave.
"The Cycle of Market Emotions" illustrates how investors may feel at different points in the market cycle (see graphic at top).
At times we may feel tempted to "move to cash until things settle down," or "get out of the market because they think it's overvalued [or there's an upcoming election, or conflict, or any other variety of reasons]." So for me, I find it helpful to ask myself this question: What is the risk of being in the market versus being out of the market?
Question 1: What is the risk of being IN the market?
I've primarily seen people lose money in the markets in three ways:
- They failed to diversify properly. They picked stocks of companies that went bankrupt, for example.
- They tried to outguess the markets. They got in at the wrong time (maybe at the top of the market cycle), and got back out at the wrong time (maybe at the bottom).
- They withdrew too much money from their portfolio too quickly.
While we cannot eliminate risk, we can design an investment strategy to help minimize it.
- We can mitigate the first risk by diversifying globally among many different stocks and bonds. For most investors, I believe the most cost-effective way to achieve this type of diversification is by using low-cost mutual funds and ETFs.
- We can address the second risk simply by staying fully invested for the long-term and not moving in or out of the market based on what we think will happen.
- We can stress test our portfolio and then commit to a reasonable withdrawal rate to minimizing the risk of running out of money due to excess withdrawal.
From my experience, everything else is usually just a temporary decline rather than a permanent loss.
Temporary declines, which are temporary, require patience, a rare commodity in today's world of high-speed internet and overnight Amazon deliveries.
Question 2: What is the risk of being OUT of the market?
Missing out on potential gains.
One may think the market is overvalued, for example, and therefore headed for a downturn. The risk in this case would be that one's feelings prove wrong, and the markets will continue their upward trend.
How significant is this risk?
Since we can't predict the future with any degree of certainty, and since our feelings are quite often wrong, we must turn to science.
On average, the U.S. market has been up about 75 percent of the time in any given year. Conversely, it has been down about 25 percent of the time. So it seems the odds would be in your favor if you simply stayed IN the markets the entire time, regardless of what markets are doing or what you think they will do.
Plus, historically some of the best days in the market usually followed (very quickly after) the worst days. Missing out on just 10 of the best best days could have really hurt your chances of success over the long run.
So the risk of being out of the markets can be pretty substantial for long-term investors who may depend on their portfolio to sustain them through retirement.
If lots of people are buying, is it time to sell?
Maybe. It may be time to sell a piece of our stock holdings, but probably not all of them. In other words, it may be time for a trim, not a complete shave. I regularly look at client portfolios for opportunities to trim gains when asset classes hit certain pre-determined thresholds, somewhere around 4-6% depending on the asset class.
Bottom Line ...
While our biggest fear may be losing money, I believe the biggest risk facing most investors is being OUT of the markets and missing out on the long-term returns the market has historically offered patient investors. Many investors who got out last year thinking they were protecting themselves against market losses may have shot themselves in the foot. Unfortunately, some may never fully recover from the loss they incurred from being out of the market.