One evening, when I was 16 years old, I was driving from my home in San Jose to a friend’s house in Morgan Hill. I was in a hurry and came across a car that was driving too slowly (probably the 45 MPH speed limit for the road). I was able to see enough of the road ahead to determine that I could pass safely, but had to cross a double yellow line to do so. Shortly after passing the car, I noticed another car, parked on the side of the road, turn on its lights and accelerate towards me. Yes, it was a police officer.
Not only did I cross the double yellow line, but I also had to accelerate beyond the speed limit to pass the “slow” car. I received the first speeding ticket of my life that evening. As a result of the speeding ticket, I had to pay a fine, attend traffic school, but also had to deal with the disappointment of my mother. (My brother tried to cushion the blow by suggesting that I tell our mother that the world is spinning about 1,000 miles per hour and what is a few more.) Gratefully I choose not to use his counsel, but ended up losing my driver’s license for a month, or so.
Unfortunately, this experience did not dissuade me from driving over the speed limit in other circumstances and I found myself over the last thirty plus years with two or three more speeding tickets. Additionally, I have experienced situations when, driving on a multilane freeway/road where one lane of traffic appears to moving more rapidly than others, I find myself changing lanes only to find my new “faster” lane quickly slows down and my old “slower” lane appears to speed up. If I am not careful, I can find myself changing lanes over and over again trying to find the fastest lane which ultimately is a very stressful (and frequently unproductive) guessing game.
At this point, you might ask “what does David’s speeding ticket and attempts to find a faster lane have to do with the stock market and investing?”. This is a great question. I think at times we find ourselves making similar decisions with investing as I did in my aforementioned driving experiences.
First, we sometimes take more investment risk than we should (just as I drove too fast and crossed a double yellow line). In my opinion, one of the most critical investment decisions someone can make is how much risk they can/should take. This issue is not simply a matter of someone being an adrenaline junkie and therefore willing/able to take more risk, but can be comprised of a number of issues including:
- Net worth
- Inflows vs outflows
- Health factors
- Intrinsic comfort with risk
- Years to retirement, etc.
Here’s a real-world example. Friends of mine have been doing a great job saving for retirement. They love learning about the stock market and love investigating different stocks that have performed well, why they performed well and love looking for the next stock that will do well. When they shared with me their investment methodology (with a large tilt towards individual stocks that are growing very fast), I encouraged them to first understand their appropriate level of risk and then invest accordingly (there is nothing wrong with fast growing, individual stocks, but you need to understand who you are before you start investing).
You might ask, what does “invest accordingly” actually mean? For some it may mean having an allocation to bonds (to reduce the overall amount of risk held by a portfolio). For others it may mean greater diversification or including some international or emerging market investments in the portfolio. The key here is that to “invest accordingly” should mean something different for each person and therefore using some other person’s investment methodology and/or not tailoring your investments for your circumstances, may result in problems down the road.
Back to my friends…from 2015 through 2019 their investments did very well (most investments did very well during this time period). However, with COVID-19 they realized that the amount of risk they were taking exceeded their comfort level (their fast-growing stocks dropped precipitously from February 19 through March 23, 2020) and they chose to cash out a large percentage of their holdings (literally on March 23, 2020 - the day the market bottomed out). On the positive side, it is good they now better understand their risk profile, but it would have been better if they had an investment methodology that incorporated their true risk profile and that minimized radical portfolio changes.
I think my friend’s experience is similar to the driving experience mentioned at the beginning of this message. They were enjoying the ride, enjoying going fast but just got “caught” (with a down market) and needed to pay the speeding ticket by cashing out of a large percentage of their holdings resulting in realizing significant losses from the market peak a month prior.
While we all understand that we are living in a world of uncertainties, we also understand that when we try to time the stock market (decide when to be in the market verses have some/all of our investment money in cash), we may miss out on some of the downturns but we will also miss the explosive upturns. Additionally, timing the market includes two very important decisions – exactly when should I get out of the market AND when should I get back into the market. Both of these decisions can be excruciating and many have identified the biggest challenge is when to get back into the market (especially after the market has had a number of good days, weeks or months).
The following chart shows the impact of missing just a few of the “best” days in the stock market from 1990 to 2019 (30 years). As you can see, if someone invested $1,000 (in the S&P 500 Index) at the beginning of 1990 and stayed invested through the end of 2019, their portfolio would have increased to $17,273 (annualized compound return of 9.96%). However, if the same person had missed the best 15 single days during that 30-year period, their portfolio would have only increased to $6,733 (annualized compound return of 6.56%).
If we look at a more recent experience and the possibly negative impact of timing the market, from March 23, 2020 (bottom of market in 2020) through August 25, 2020 (five months later), the Dow Jones Industrial Average, S&P 500 Index and the Nasdaq Composite increase by 51.94%, 53.91% and 67.13%, respectively (see attached chart). We are reminded that the stock market had a significant drop prior to this time period, but those who tried to time the market by being in cash missed out on this significant recovery.
Second, my earlier example of changing lanes can also be likened to timing the market. Some people try to get in or out of the market sensing upcoming challenges. The problem with this is that, when in cash, it is as if you not only change lanes, but you also pull over to the side of the road and simply stop. The thought is that stopping (being in cash) will help me avoid future problems, but when the traffic (stock market) picks back up, it may be difficult (mentally) to get back in. From an investment point of view, we may think we missed the market upswing and may be afraid of a future pullback in the market.
Additionally, some people spend time chasing performance. “What mutual fund (stock, ETF, international, domestic, etc.) did well last year – that’s the one I should be in now” type of mentality. Similar to changing lanes, these situations can be stressful and frequently is an unproductive guessing game.
One of the keys to a greater expectation of a successful stock market experience is to better understand who you are, the amount of risk you are comfortable taking in the stock market and implement an investment methodology that you can utilize during the good and hard times. As you do so, you avoid the anxiety of constantly changing lanes and the possible effects of the speeding ticket (getting “caught” in a bad stock market) including the monetary fine (arbitrarily selling your investments at a possibly low).
At Montage Financial Advisors, we strive to help people have a better investing experience. We do this by focusing on the things that you can control:
- Create an investment plan to fit your needs and risk tolerance.
- Structure a portfolio along the dimensions of expected returns.
- Diversify globally.
- Manage expenses, turnover and taxes.
- Stay disciplined through market dips and swings.