2/4/14 – What to Do?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 4, 2014 8:03:55 AM

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I had a good talk yesterday with two journalists whom I respect quite a bit, Pimm Fox and Carol Massar of Bloomberg Radio’s Taking Stock. We started off discussing the markets, why things were down, and what might happen, and then they asked an excellent question: what should an investor do, and why?

It was so good a question, in fact, that I didn’t have a good, short answer. So much depends on the investor’s plan, his or her time frame, risk tolerance, and so on and so forth that it’s almost impossible to come up with a succinct response.

What I did say, though, was—in my not-so-humble opinion—about as good an answer as you will get. I said to just sit tight.

Note that I didn’t say to hold on no matter what. I didn’t say the market was going to go back up; in fact, I noted that it might well continue to decline. I didn’t say everything was okay. I said to sit tight.

The reason I said that, in that way, was I believe that an investor who makes a decision on short-term, unexpected market moves is making a mistake. It may turn out well, but it will still be a mistake. The average investor fails because he or she makes short-term decisions based on emotion. Our brains are wired to fail as investors. There have been many studies proving this, so anything you really, really want to do is probably exactly the wrong thing. Sitting tight means not making a short-term, emotional decision.

Any investor who wants to succeed has to figure out a way to get around the cognitive biases that program us for failure. Asset allocation and rebalancing are one way to force ourselves to do this. Another is to (at a calm time when you can think rationally) prepare a plan that lays out what you will do under various scenarios. Anyone who had done that before the recent decline would now know what he or she would do—and when. That wouldn’t make the decline any more fun, but it would remove much of the uncertainty. That plan, by the way, should include a decision rule to get back into the market, as well as one to get out.

Easily said. Let’s look at an example based on a paper I wrote a couple of years ago. The paper concluded that when stocks were expensive according to the Shiller P/E, as they are now, getting out of equities when the market dropped below its 200-day moving average resulted in higher long-term average returns over multi-year periods. If you were following that rule, you would be waiting for the S&P 500 to drop below the 200-day moving average; then you would get out of stocks and wait until the index moved back above it to buy back in.

Note that this was a thought experiment, and I am explicitly not recommending it as a trading strategy. It also has multiple drawbacks—trading costs, transaction costs, and taxes being big ones, but also the near certainty that the strategy will underperform when the market is going up. Nonetheless, this can provide the basis for a rule-based decision that might guide you to, for example, shift from a stock-focused portfolio to a more fixed income- or alternative strategy-focused portfolio as the market drops. If you have a financial advisor, he or she can help you with that. There are many ways to de-risk a portfolio, and a simple rule that lets you know when to do that could potentially provide meaningful longer-term improvement in performance.

I am following my own advice and sitting tight at the moment. But I continue to watch the markets, and when appropriate, I will take the actions I decided on some time ago. Right now, the market is correcting back to a normal, healthy place from what I considered to be an overvalued level. In my opinion, this is actually a good—if uncomfortable—thing. If you have a diversified portfolio, matched to your risk tolerance and time frame, this should only be a blip, which you’ll likely forget about in the next couple of years.

If, however, you really are uncomfortable right now, you should probably reevaluate your holdings. This is a minor downturn, and if it bothers you, you’ll never make it through a real one. Plans are great things, but they have to be something you can actually execute. If you can’t sit tight with this (so far minor) decline, you need to come up with a plan where you can.

Upcoming Appearances

Tune in to CNBC's Power Lunch on Wednesday, February 26, between 1:45 and 3:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Check local listings for availability. 

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

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