The most simplistic advice is often the best, and there’s very little that is simpler or better than “Stay invested.”
Countless studies have shown that investors have terrible timing, awful instincts and, accordingly, bad results. The landmark Quantitative Analysis of Investor Behavior from Dalbar has measured investment results compared to the stock market for a quarter-century now, and it has repeatedly proven that investments do better than investors.
The problem is that investors typically buy into stocks and funds only after a run of good performance; they bail out during/after a decline, thus completing a cycle of buying high and selling low.
The long bull market narrowed the gap; investors generally were content to ride the long wave through short troughs.
But about a year ago, a relatively short downturn, proved steep enough to change investor behavior. Investors started freaking out as the market showed signs of stress in October 2018; as a result, the Standard & Poor’s 500 was down 6.84 percent for the month, but the average investor lost nearly 8 percent, according to Dalbar.
By the time 2018 ended — with a swoon in December — the gap was huge; the market lost 4.4 percent, but the typical investor dropped more than twice that much, to the tune of nearly 9.5 percent.
Yes, anyone who stayed invested throughout finished the year down, but someone who got out — trying to save themselves — made out worse, according to Dalbar. The market then added insult to injury, snapping back in January as the panicky crowd settled into the sidelines and counted their losses.
Now let’s bring the focus to today’s market, where it’s easy to find experts who are bullish, bearish and anywhere in between. The optimist feels good about continued expansion of gross domestic product, low unemployment, ultralow inflation and more, while the pessimist expects trouble due to trade issues with China, the uncertainty caused by Brexit and the inverted yield curve.
How much you fear the negative should depend more on your personal situation than the market itself.
Financial advisers have long talked about “sequence-of-return risk,” the chance of a market downturn right at the beginning of retirement, as an individual transitions from the accumulation phase — when they’re working and saving — to the distribution phase, when they start living off their savings.
Studies show that a significant downturn at the start of retirement can dramatically alter how long a nest egg lasts; conversely, a few good years at the beginning of retirement can make the entire journey more easily.
For that reason — and just because losses scare the heck out of people — near-retirees and seniors who get nervous tend to leave the market when times get frightening.
“They’re always going to be better off staying invested,” said Louis Harvey, Dalbar’s chief executive. “Historically, in 85 percent of the market downturns, markets recover from severe declines in three months.”
But not every downturn ends so quickly, which is where the scare factor and panic set in.
So Harvey and the Dalbar crew looked at the problem trying to find the right strategy to pursue if you actually feel the need to freak out a little bit, if you can’t simply “stay invested.”
This is when many investors turn to indexed annuities and other complex financial products that basically provide some measure of protection against a downturn. Typically, these products are costly and their effectiveness is limited.
So Dalbar’s experts came up with a different solution, a strategy they call “un-panicking investors.”
Obviously, an investor who is not panicking is staying invested, rather than cashing out. But Dalbar suggest taking the additional step of buying something called “an index put.”
Before your eyes glaze over, here is a quick lesson in index options. I promise it will be brief and that you’ll learn something about yourself in the process, even if you still struggle to understand options.
An index put option gives you the right to sell the underlying index at a specific price until the option expires. Thus, if you buy an index put option at roughly the current trading price and the market declines, you can sell at the current price, meaning you avoid loss.
The point is to pair an index put as a hedge against your portfolio. If the core of your portfolio is an index fund — and you buy an index put to support it — the option effectively offsets your index losses during a market decline.
That is a vastly simplified explanation, but think of this like buying portfolio insurance. You pay for insurance to protect against things you can’t afford to lose or replace; you buy insurance hoping to never need it.
The same goes with the index put for your portfolio. If the market goes up, it eventually expires worthless — the same way that your auto insurance doesn’t “pay off” if you never have an accident — but you have coverage in case anything bad happens.
There are different ways to implement this kind of strategy — institutional investors have funds built of puts and financial advisers can often access puts that have been pooled together — but there isn’t a mutual fund that you can just buy and hold like a bear-market fund to make this work.
You can do it yourself, however, but there is a bigger point here, namely that if you fear complexity and confusion — which are byproducts of annuity and other strategies designed to avoid loss — you can skip the whole thing and go back to the simplest, best advice: Stay invested.
Rebalance your portfolio, get back onto plan, but fight the urge to bail out at the wrong time. If you can’t do it yourself, consider an index-put strategy, or tactical allocation moves and more that eases any potential pain, but stick with the market.
Said Harvey: “The index-put strategy works for someone who feels like they must do something. But for most people, the best strategy is still — and always — going to be ‘Do nothing. Ride it out.’”
Copyright, 2019, J Features