Take a deep breath, and let Iron Mike lend a hand.
When Mike Tyson was asked about an opponent’s supposedly clever plan for protecting against his devastating left hook, he had an immediate response:
Everybody has a plan until they get punched in the mouth.
Tyson probably wasn’t thinking much about investing when he made the observation above, but his words are just as applicable to retirement planning as they are to boxing.
If you’re reading this, odds are that you — or your portfolio at least — has just been punched squarely in the mouth. It’s been a rocky day in the markets. Hard earned savings have disappeared in an instant. The floor traders at the NYSE appear to be panicking. CNBC is in full-blown “circus mode.” It seems that everyone is selling their stocks today — why shouldn’t you?
It turns out that you especially should not sell your stocks today. So take a deep breath, and do a bit of reading before you click the “sell” button at E-Trade.
Reason #1: History Says Market Timing Is Risky
In 2008, Javier Estrada published Black Swans and Market Timing: How Not To Generate Alpha, which reached the following conclusion:
The evidence, based on more than 160,000 daily returns from 15 international equity markets, is clear: Outliers have a massive impact on long-term performance. On average across all 15 markets, missing the best 10 days resulted in portfolios 50.8% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 150.4% more valuable than a passive investment. Given that 10 days represent, in the average market, less than 0.1% of the days considered, the odds against successful market timing are staggering.
As Estrada notes in his paper, “black swans render market timing a goose chase.”
Reason #2: Fortunes Are Made in Minutes
Similar conclusions can be reached without a full blown research paper. Ford’s entire stock price — and the company’s $60 billion market cap — is the sum of just 10 trading sessions since 2013:
The entire value of the Dow Jones Industrial Average was accumulated in about 36 sessions — or about 235 hours worth of trading activity. Investors who move to cash remove the downside risk of further losses, but they also remove any potential gains. And historically, increases in the stock market have been swift and unexpected.
Reason #3: Your Recency Bias
When stocks plunge, investors are exposed to one of the numerous behavioral traits that so often works against them: the recency bias. In short, humans tend to assume that the most recent results will continue in the future.
Carl Richards explains how this bias can wreak havoc on portfolios:
When the market is down, we become convinced that it will never climb out so we cash out our portfolios and stick the money in a mattress. We know the market isn’t going back up because the recency bias tells us so. But then one day it does, and we’re left sitting on a really expensive mattress that’s earning nothing.
For short periods of time, the mattress may be the best place to store your cash. But over the long haul, investors tend to do better when they can ignore the pull of the recency bias and remain invested in the markets.
Reason #4: Loss Aversion
Most have heard some variation of the idea that “investors are their own worst enemy” at some point. This challenge takes a number of forms, including the recency bias discussed above. Most notably, investors tend to be risk averse and loss averse; studies have demonstrated that “changes that make things worse (losses) loom larger than improvements or gains.”
Specifically, individuals feel losses twice as strongly as gains — which explains why most investors are sick to their stomachs when they see a large negative number on their account statement.
Research Says Investors Are Terrible Market Timers
Market timing is a high risk / high reward activity. Unfortunately, most investors are terrible at market timing — meaning that they are likely to do harm to their portfolio.
Countless academic studies and papers have examined investor behavior in various environments, and reached generally similar conclusions. Below is a sampling of the research on the ability of investors to effectively move between risk free and risky assets.
Reason #5: Investors Lag Their Funds
A 2007 study published by Geoffrey Friesen and Travis Sapp examined cash flow data available for individual mutual funds, and determined that between 1991 and 2004 investors reduced their average returns by 1.56 percent annually.
In other words, the returns realized by investors lagged behind the returns on the funds in which they invested, due to a tendency to buy after seeing strong performance (i.e., return chasing) and sell after big declines (i.e., panic selling).
Reason #6: Timing Costs 2.5 Percent Annually
Morningstar estimates that the “costs” investors incur as a result of their poor market timing skills equal roughly 2.5 percent annually.
Reason #7: Woe of the “Average Investor”
Richard Bernstein Advisors calculated the returns realized by an “average investor” over a 20-year period using mutual fund sale and redemption data, and compared them to the various asset classes:
Reason #8: Wall Street Sentiment
Bernstein also tracks a metric called the “Wall Street Sentiment Indicator,” which measures the consensus allocation to stocks recommended by Wall Street strategists. In 2012, Bernstein made a bull case based on this indicator — which was at its lowest level in decades:
As shown above, strategists tend to be influenced by recent trends in the market — which causes them to make poor allocation decisions:
Wall Street strategists never recommended overweighting equities at any point during the entire bull market of the 1980s and 1990s. They finally recommended overweighting equities subsequent to the Technology bubble. That overweight proved to be just in time for the so-called “lost decade in equities”, during which US stocks produced a negative return over 10 years.
Reasons #9 and #10: Most Amateurs “Do Far Worse”
Morgan Stanley strategist Gerard Minack compiled information on flows in “aggressive growth” funds overlaid with performance of the stock market. Not surprisingly, the data shows that investors tend to buy these funds when they have been performing well and sell them when they have been struggling:
The results of this strategy are disastrous; rather than realizing a modest (albeit volatile) return, market timers would have lost most of their money:
Minack sums up the ramifications of these charts nicely:
In short, amateurs may be able to beat the investment professionals, but most do far worse. This keeps professional investors in business (and that keeps people like me employed, which is nice). But it means that returns to investors typically lag benchmark returns by a long margin.
Reason #11: Danger of Capitulation
The always insightful Rick Ferri illustrates a similar point using fund flows data from the Investment Company Institute plotted along with total returns:
In the accompanying post, Ferri explains why market timing can be so devastating:
Bad things can happen when an individual investor unintentionally times the market due to emotion. Being wrong once means getting out at the wrong time, or not getting back in at the right time. Being wrong on both can lead to long-lasting detrimental effects. Capitulation in a bear market and then sitting out during the recovery creates deep psychosocial damage. This damage can keep investors away from the markets for an extended period of time – sometimes for life.
Reason #12: The Return Gap
Jason Hsu of Research Affiliates examined the performance of various stock mutual fund types between 1991 and 2013, calculating the difference between the dollar-weighted return investors experienced and the hypothetical buy-and-hold results. He found that investors underperform by nearly 200 basis points annually:
During a recent presentation, Hsu attributed this underperformance to the fact that “people make bad decisions all the time and everywhere.” Investors who attempt to chase trends end up incurring extra transaction costs while also missing out on mean reversion.
Reason #13: Hazards to Wealth
A 2000 paper by Brad Barber and Terrance Odean examined the trading activity and investment performance of more than 66,000 households, reaching some depressing — though predictable — conclusions:
Of 66,465 households with accounts at a large discount broker during 1991 to 1996, those that trade most earn an annual return of 11.4 percent, while the market returns 17.9 percent. The average household earns an annual return of 16.4 percent, tilts its common stock investment toward high-beta, small, value stocks, and turns over 75 percent of its portfolio annually. Overconfidence can explain high trading levels and the resulting poor performance of individual investors.
In illustrating how high turnover costs correlates with poor performance, the authors state a straightforward conclusion from their research: “Our central message is that trading is hazardous to your wealth.”
Reason #14: Roulette Wheels
In 2001, Richard Bauer and Julie Dahlquist published Market Timing and Roulette Wheels in the Financial Analysts Journal.
Using a new measure of investment performance that we call the “roulette wheel” measure, we analyzed monthly, quarterly, and annual market-timing strategies in the 1926–99 period for six major U.S. asset classes. In the 1995–99 period, buying and holding large-capitalization stocks would have outperformed about 99.8 percent of the more than 1 million possible quarterly switching sequences between large-cap stocks and U.S. T-bills.
The period in question here coincides with the tail end of a massive bull market, so the dominance of buy-and-hold isn’t all that surprising (though there were 30 days where the S&P lost at least 2 percent during this stretch).
Reason #15: Benefits of Blindness
In the late 1980s, psychologist Paul Andreassen conducted an experiment with business students at MIT.
Andreassen divided students into two groups. Each group selected a portfolio of stocks and knew enough about each stock to come up with what seemed like a fair price for it. Then Andreassen allowed one group to see only the changes in the prices of its stocks. Students in that group could buy and sell if they wanted, but all they knew was whether the price of a stock had gone up or down. The second group was allowed to see the changes in price and was also given a constant stream of financial news that supposedly explained what was happening with each stock. Surprisingly, the less-informed group did far better than the group that was given all the news.
Students with access to headlines traded much more frequently than those who only saw price movements — which led them to perform worse than the “headline blind” group.
Reason #16: Mortal Fund Managers
The tendency to mis-time the market is not only a characteristic of individual investors; it also exists among mutual fund managers. A 2010 study of UK mutual funds by Keith Cuthbertson, Dirk Nitzsche, and Niall O’Sullivan reached the following conclusion:
A relatively small number of funds (around 1%) demonstrate positive market timing ability at 5% significance, while around 19% of funds exhibit negative timing and on average funds mis-time the market.
The above represents only a partial case against giving in to panic or trying your hand at market timing. Though the potential rewards are great, the average investor will do more harm than good. As columnist Hane Bryant Quinn once wrote, “the market timer’s Hall of Fame is an empty room.”
History Says: Over the Long Haul, Stocks Are Winners
The bad news for investors is that market timing is nearly impossible to do with any level of consistent success.
The good news is that the stock market has a long history of generating meaningful, positive returns for investors with the patience to ride out the short-term volatility.
The charts and anecdotes below illustrate the tremendous potential of investing in stock markets over extended periods of time — both for fictional characters and everyday men and women.
Reason #17: Rocky Balboa’s $750,000 Fight
Prior to stepping into the ring with Apollo Creed, Rocky Balboa had never made more than $400 for a fight. As he told loan shark Tony Grazzo in “Rocky II,” Balboa netted about $37,000 for his 1976 showdown. Grazzo encouraged Rocky to invest in condominiums, but perhaps a wiser choice would have been the market; if invested in the S&P 500, that $37,000 would have grown to nearly $750,000 by 2015.
See more examples of how movie characters could have made it big in the market — including Henry Hill’s missed $129 million opportunity.
Reason #18: The Dow’s Dominance
Consider an investor in early 1982, reviewing the 21 stocks that would eventually become components of the Dow Jones Industrial Average with plans to invest $10,000 into one of them. Picking Apple (AAPL) would have been quite smart, but an investment in Home Depot (HD) would have done even better; that $10,000 would have grown to more than $28 million by 2015.
If the investor had made the absolute worst possible selection and invested $10,000 in IBM, however, the outcome would have hardly been disastrous; the initial investment would have grown more than 20x to about $209,000.
Reason #19: The $8 Million Man
Investment results of this magnitude aren’t limited to fictional characters or hypothetical investment, as the story of Ronald Read illustrates. Read, who lived through the Great Depression and served in World War II, accumulated a portfolio of more than $8 million by consistently saving portions of his salary as an employee of a Vermont service station and JC Penney.
Read liked to pick stocks, so it’s possible that skill or luck contributed to his nest egg. But even simple investments in diversified portfolios would have done quite well; every $100 he invested in 1945 would have grown to nearly $175,000 by the end of 2014.
For investors like Read, who put away additional money each month, stock market pullbacks become opportunities to buy cheap.
Reason #20: Black Monday, in Hindsight
The worst single day decline for the S&P 500 occurred on “Black Monday” in October 1987, when the benchmark lost more than 20 percent. That session no doubt seemed devastating to investors at the time. But for those who remained invested in the market, it is barely noticeable on a long-term performance chart:
Black Monday was no doubt painful for investors; a single-day decline decline in the S&P 500 of more than 20 percent is almost unimaginable today. But an even worse fate belonged to those who liquidated immediately afterwards, and sat on the sidelines as stocks recovered and reached new highs.
Reason #21 and #22: When Markets Bounce Back
Below is a summary of stock performance after a big single day drop. The jump in the next session is minimal (and positive), but the average return over the next year is meaningful:
It is much less common for the S&P to drop by 3 percent or more in a single sessions — this has happened 97 times since 1950, while a drop of 2 percent or more has occurred nearly 350 times. Following a 3 percent drop, the bounceback tends to be even larger:
There are plenty of examples of prolonged downturns, when additional pain followed for months and years after big single day drops in markets. But eventually, those who stay the course tend to be made whole.
Reasons #23 and #24: 140 Character Wisdom
Investors tend to focus on the magnitude of the past losses, and not the future opportunities. Put another way:
humans have a unique ability to be "concerned" about an event or issue after it has already happened. Therein lies an opportunity.
— Bert Macklin (@buckdeerstocks4) August 28, 2015
Or, to use a more concrete example:
If you sold your stocks the Friday before Lehman went bankrupt, went to cash & stayed there you would have missed out on a gain of 93%
— Ben Carlson (@awealthofcs) July 14, 2015
As Ben explains in a longer post, investors would have had to first endure the loss of 45 percent. That may seem impossible — the pain of losing nearly half of a portfolio is significant — but, as Ben points out, “the fact that so many people feel that a strategy is impossible to pull off is the exact reason that it works over time.”
Reason #25: Weakest Believers
The legendary personal finance columnist Jason Zweig, writing in September 2009, expressed a similar thought on the challenge of enduring selloffs:
To prevail as a successful long-term investing strategy, buy-and-hold has to go through a prolonged period when it no longer seems to work. As its weakest believers give up and fall away, buy-and-hold will ultimately emerge stronger.
He goes on to mention that this “prolonged period” is, unfortunately, often longer than a few months or even a few years. (By the way, Zweig notes that his portfolio now is “virtually indistinguishable from what [he] put together around 1994.”)
Investing Legends Don’t Think You Should Sell Stocks
Many of the most successful investors have lived through multiple periods of extreme market volatility and lived to tell about it. Their advice generally advocates patience, perspective, and an opportunistic mindset.
One of Warren Buffett’s most widely-shared quotes advises investors to “be greedy when others are fearful.” In his 2014 shareholder letter, Buffett elaborated on this idea (emphasis added):
The main danger is that the timid or beginning investor will enter the market at a time of extreme exuberance and then become disillusioned when paper losses occur. (Remember the late Barton Biggs’ observation: “A bull market is like sex. It feels best just before it ends.”) The antidote to that kind of mistiming is for an investor to accumulate shares over a long period and never to sell when the news is bad and stocks are well off their highs. Following those rules, the “know-nothing” investor who both diversifies and keeps his costs minimal is virtually certain to get satisfactory results.
These ideas pre-date Buffett of course; 18th century British nobleman Baron Rothschild is credited with the following advice:
Buy when there’s blood in the streets, even if the blood is your own.
When Benjamin Graham authored “The Intelligent Investor” in 1949, he specifically noted the self-created investing hurdles:
The investor’s chief problem – and even his worst enemy – is likely to be himself.
Warren Buffett has cited patience as one of the most important characteristics of a good investor on numerous occasions:
The most important quality for an investor is temperament, not intellect. You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.
In a 1995 interview with BusinessWeek, Buffett made a similar point:
Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.
William Bernstein, a best-selling financial author and theorist, believes that investors fall into one of two buckets:
There are two kinds of investors, be they large or small: Those who don’t know where the market is headed, and those who don’t know that they don’t know.
Bernstein also proposes two types of risk: shallow risk, defined as “a loss of real capital that recovers relatively quickly” and deep risk, defined as “a permanent loss of real capital.” In one of his books, “stocks protect against deep risk, but exacerbate shallow risk.”
After receiving the 2002 Nobel Prize in Economics, Daniel Kahneman was asked by a CNBC host to share investment tips with the audience. His response was straightforward:
Buy and hold.
Legendary investor Jesse Livermore credits his patience — and ability to wait out adverse conditions — with much of his success:
It never was my thinking that made the big money for me. It always was my sitting.
Dr. Jeremy Siegel, author of “Stocks for the Long Run,” advocates patience instead of panic:
Winning with stocks requires only patience, not foresight.
It should be no surprise that Vanguard founder Jack Bogle advocates a buy-and-hold approach to investing; he’s never hesitated to ridicule the idea of market timing:
After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.
For more insights on market timing from experts, see this Bogleheads thread.
Modern Experts Don’t Think You Should Sell Stocks
Insights into market timing and investor psychology aren’t limited to the legends of investing; plenty of modern managers and authors have added to the conversation as well. Below are a handful of additional insights:
John Hussman, generally considered to be a bearish fund manager, may seem to be an unlikely advocate of buy-and-hold investing.
I have no intention of encouraging investors to deviate from other disciplines.. Jack Bogle of Vanguard is a good example of the right mindset on this – he encourages a buy-and-hold approach, but he also understands…the likelihood that the coming decade will include a number of interim market losses in the range of 30-50%.
Appearing on the Masters in Business podcast, James O’Shaughnessy had a brilliant observation about investor performance:
Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was… they were the accounts of people who forgot they had an account at Fidelity.
Robert Novy-Marx, a professor of finance at the University of Rochester, nicely sums up market timing:
You might get it right – and someone always does, and they’re happy to tell you what a genius they are. But you are just as likely to sell too early, or get back in too late, or too soon.
Larry Swedroe, Director of Research at BAM Allience, is skeptical of short-term market predictions:
Believing in the ability of market timers is the equivalent of believing astrologers can predict the future.
The entertaining and informative Eddy Elfenbein has a very simple philosophy: buy and hold shares of outstanding companies. Below is a summary of his view of stock markets:
The stock market is simply the most consistently successful way to make money over the long term…While the stock market may bounce around from day to day, and even month to month, the long-term trend has always been higher. Over the last 40 years, stocks have gone up 100-fold. And since the end of World War II, the stock market is up an amazing 145,000%. I wish I had been around! That was the beginning of an American financial revolution. Today, we’re at the beginning of a global financial revolution. That’s why I think the next 70 years will be even better.
In a brilliant rebuttal to the suggestion that panic selling is a productive response, Morgan Housel lays out several impressive stats:
- In 2008, the median stock in the Russell 3000 fell by 39 percent; over the next three years, the median return was 67.8 percent.
- Stocks lost 89 percent of their value between 1929 and 1933; over the following five years, they rose more than 800 percent to get back to even.
- Between 1980 and 2014, 40 percent of companies in the S&P 500 suffered a “catastrophic loss,” meaning they lost 70% or more of their value and never recovered. But the S&P 500 went up 50x over that period, including dividends.
Housel’s point is that big busts tend to be followed (eventually) by big booms. Though it can take a long time to recover fully, moving to cash generally doesn’t help.
Reasons #43, #44, and #45: Pullbacks Are Good (For Some)
For retirees who have finished making contributions to their investment accounts, there is no silver lining to a big selloff. But for younger investors who have savings opportunities ahead of them, short-term declines are actually beneficial.
Consider a hypothetical scenario in which:
- An investor makes contributions of $20,000 each year; and
- The portfolio returns an annualized rate of 5.2 percent over a 16-year horizon.
The blue line below shows the growth if there is zero volatility. The yellow line shows the growth if stocks performed as they did between 1999 and 2004 — with significant volatility.
A big decline means a chance to buy stocks at a reduced price, but most investors aren’t able to see the long-term opportunities when facing the short-term losses. Put another way:
The stock market is the only market where things go on sale and all the customers run out of the store….
— Cullen Roche (@cullenroche) August 24, 2015
Aside from the “bargain shopping” opportunities created, the presence of downside risk in stock markets also creates the tremendous upside potential. As Josh Brown explains:
The only reason stocks can go up is because they can also go down. It is this risk that keeps investors in check and that keeps people from paying an infinite amount of money for shares in a business. The reintroduction of risk, in the context of [the 2015 summer] sell-off, is the best thing that could have possibly happened.
Reason #46: Bogle’s Advice
Vanguard founder Jack Bogle has provided plenty of investing advice over the course of his lengthy career. In addition to advocating low-cost indexing strategies, he’s suggested that investors distance themselves from the day-to-day — and even year-to-year — fluctuations in their portfolios:
Don’t even peek at your account; don’t open those 401(k) statements. If you don’t look at your 401(k) statement–this sounds outrageous, but it’s true–for 45 years…you start when you’re 20 and you don’t open a single statement for the next 45 years, when you open that statement the day you retire, you are going to go into a dead faint of amazement about how much money you’ve accumulated.
Bogle’s advice is intentionally extreme, but his general advice is sound.
Reasons #47 and #48: Stepping Away
Consider an investor who checked his stock portfolio at the end of 1999, and then fell into a deep sleep for 15 years or so. Awakening in August 2015, his understanding of the Dow’s movement would look something like this:
In reality, of course, the climb was anything but even. The actual path taken between these two endpoints saw periods of both huge increases and dramatic losses:
While the investor Rip Van Winkle is likely pleased with the 44 percent gain that accrued during his sleep, investors who check in more regularly will have experienced some significant stress. During this period:
- Lost 500 points or more in 14 different sessions;
- Lost between 100 and 500 points during another 638 sessions; and
- Spent 53 percent of the time at least 10 percent below the previous high.
Between January 2000 and August 2015, the Dow gained about 5,100 points, or 44 percent. During the 10 best sessions during that stretch — out of nearly 4,000 trading days — the Dow saw an aggregate gain of 5,982 points.
Investors who were spooked by the numerous freefalls during this stretch may have missed out on some of these sessions. Sitting on the sidelines for those two days in October 2008 would have meant missing out on more than one-third of the total rally.
Reason #49: History Always Rhymes
Hopefully the evidence and insights above have helped to calm your market-related anxiety, and perhaps even convinced you to reduce the frequency of your account reviews. If not, perhaps one more line from Jason Zweig will do the trick:
This time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.
Have another study that is relevant? Conflicting evidence? Please share in the comments below.
About the Author: Michael Johnston
Michael Johnston is senior analyst for Fund Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.