2022 has been an extremely bad year for almost every asset class! Stocks and bonds have suffered large losses. And inflation has been high, further eroding the value of investors’ savings. In a bear market, it is absolutely critical for long term investors to avoid panic selling at all costs.
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I recommended to all of my investors that they stay the course and keep to the allocation we had decided upon. Based upon the performance of the market, I was wrong! Like, very wrong.
In early 2022, several clients approached me about shifting allocations away from riskier assets. Many, at the time, were concerned with Russian aggression, as well as the risks of the Federal Reserve Open Market Committee (FOMC) taking aggressive action to fight inflation. And now as the third quarter of 2022 comes to a close, we have indeed experienced a major bear market, mostly due to those reasons.
Are you results-oriented or process-oriented?
But, back then, I recommended to all of my investors that they stay the course and keep to the allocation we had decided upon. Based upon the performance of the market, I was wrong! Like, very wrong. But I still think that I made the correct decision, and followed the correct strategy. In investing, it’s important to be process-oriented, and not results-oriented. The difference between being process oriented and results oriented is that a process-oriented investor focuses on the strategy that they have put in place, and not on the results of that strategy. A results-oriented investor, on the other hand, focuses on the results of their strategy, and not on the strategy itself.
For example, a process-oriented investor would focus on the fact that they are diversified across asset classes, and not on the fact that their portfolio is down for the year. A results-oriented investor would focus on the fact that their portfolio is down for the year, and not on the fact that they are diversified. The problem with being results-oriented is that it can lead to bad decisions. For example, if an investor is focused on the fact that their portfolio is down for the year, they may be tempted to sell their assets and get out of the market. However, this would be a bad decision, as it would likely lead to missed opportunities and lower returns.
Diversification and proper asset allocation will always trump individual annual results
At Luther Wealth, I am highly process-oriented. In particular, I am focused on getting the asset allocation decision right, using a proprietary algorithm to generate well-diversified optimal portfolios. I believe that, in the long run, a properly diversified portfolio will earn good returns, irrespective of year-to-year ups and downs.
Why you shouldn’t panic sell in a bear market
When the stock market crashes, it can be tempting to sell all of your assets and get out while you still can. However, this is usually not the best course of action. Here are a few reasons why you shouldn’t panic and sell during a market downturn:
- The market always recovers eventually. No matter how bad the market crash may seem, it will eventually recover. If you sell all of your assets during a crash, you’ll miss out on the rebound.
- You could lose money if you sell during a crash. If you sell during a market crash, you’ll likely sell for less than you paid. It’s better to wait until the market recovers to sell.
- You could miss out on future growth. If you sell during a market crash, you’ll miss out on the potential for future growth. The market always has the potential to rebound and grow, so it’s best to stay invested.
- You could miss out on dividends. If you sell during a market crash, you’ll also miss out on any dividends that your investments may have paid. Dividends can provide a valuable source of income, so it’s best to hold onto your investments.
- You could end up with a higher tax bill. If you sell during a market crash, you may end up with a higher tax bill. Capital gains taxes are based on the difference between your selling price and your purchase price, so you could end up owing taxes on your gains. This is particularly relevant for securities that you might have owned for a long time. These securities might have large unrealized gains associated with them, despite the recent losses.
A lesson from recent history
A good illustration of this behavior can be found in the stock market crash of 2008. The stock market crash of 2008 was one of the worst in recent history. Many investors sold their assets during the crash, only to miss out on the rebound that followed.
In fact, let’s take a look at how a hypothetical investor would have made out if they had picked the exact wrong time to invest in the stock market, in November 2007. If they had maintained their investment through the downturn, their 10-year investment return would have been 8.2%. That’s great!
On the other hand, if they had sold their equity position after Lehman Brothers collapsed, and then re-invested in February 2013 when markets had fully recovered to pre-crash levels, their 10-year investment return would have been just 3.7%. As you can see, it’s important to stay invested during a market downturn. Selling during a crash can lead to missed opportunities and lower returns.
Big short term losses are the table stakes for big long term returns
In general, the asset classes that earn the largest returns over the long term, are also the asset classes that can suffer the biggest losses in any given year. This means that if you want a portfolio that grows big for your retirement, you simply need to be okay with a big annual loss now and again!
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