Avoiding the Temptation to Flee During Times of Economic Uncertainty
March 26, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial
In light of the coronavirus and the economic downturn that followed, it has become extremely tempting for many people with money in major markets to exit their positions and “cut their losses” before things begin to get any worse. After all, we might reason with ourselves, if the stock market has already retracted by 30 percent, what’s to stop it from dropping 30 percent further? The economic uncertainty we are facing right now is paralyzing many with fear.
While falling into the traps of behavioral biases—which occur when emotion triumphs over reason—may be something our instincts are telling us to do, this is really the opposite of what people should be doing during any period of broader market economic uncertainty. Exiting carefully selected positions after money has already been lost will effectively “lock in” these losses and have a permanent impact on your portfolio’s long-term performance.
Rather than listening to our gut instinct to flee, it is crucial to weather this inevitably passing financial storm and keep moving forward.
Making it More Difficult to End Up on Top
To simplify things, suppose your entire portfolio consisted of one stock (representative of the whole market) that at the beginning of the year was valued at $100. If, following the recent market downturn, the stock dropped to $70, you might decide to jump ship, fearing that it is “destined” to keep dropping to $60, $50, or even $40.
History shows us that the market retracts on a very regular basis. 1931, 1974, and 2008 were three terrible years for the stock market and all three of these years were measurably worse than what we have experienced thus far in 2020. However, eventually, these losses were followed by gains. In 1931, the S&P 500 lost 47 percent of its value, but in 1933, the same index experienced a 47 percent gain (which still equates to a net loss, but still shows just how quickly these trends can be reversed). Even while including these major losses, the index grows by about 9.5 percent per year on average, showing that sticking things out is still a reasonable strategy.
In the example above, a person deciding to exit at a low point of $60 would soon find themselves worse off, especially if they hoped to ever reenter the market. As the stock rose to $90 two years later, which is significantly more likely (and actually happened during the depression) than the market never turning around, the person who had stuck things out would be down only $10 while the person deciding to jump would be down $40.
As the market continues to grow, the person who was patient would be even better off and eventually back in the black. Extend these decisions to the size of your entire portfolio and you will see what a difference having confidence in your original plan can make.
It is easy to want to jump ship because dramatic changes in the market are scary and we simply want our losses and economic uncertainty to end. But even looking at the “great recession”—which was measurably more complicated than the current coronavirus downturn—of 2008, it only took four years for the DJIA and S&P 500 to regain their losses, leaving their investors exactly where they started. Then, over the course of the rest of the decade, both indexes roughly doubled in value.
Four difficult years followed by eight prosperous years, multiplied over the course of a lifetime, will leave you in a much better position than you started in. These boom-and-bust cycles, while they may change shape, length, and form, occur on a very regular basis. Deciding to exit during market busts and only enter when the market is booming, on the other hand, will have a tremendously negative impact on your final ROI.
Understanding Your Financial Plan and Sticking with It
When emotion begins to overwhelm reason, it can be easy to forget that your original financial plan was not designed in a vacuum. Yes, the COVID-19 fallout certainly came as bit of a surprise, but your portfolio was carefully designed knowing that someday, some type of market retraction would happen, even if we were initially unsure when and what this day and type might be.
The path between the status quo and your future financial goals was never intended to be a straight line. Your plan was created knowing that some losses should be expected to occur, knowing that they will eventually be regained.
If you are still having doubts, think back to the day you crafted your portfolio, when you could see the market clearly and knew these cycles would inevitably occur.
Keeping these things in mind, what would past you want present you to do?