It has been a rough year for investors. U..S stock indexes have plunged into correction territory (down 10 percent from the recent peak) for the second time in six months and the big swings are testing every investor’s internal fortitude. The bad start to the year is causing a bit of déjà vu all over again, especially given the dire predictions of some economists and analysts. The current situation is not like 2008, primarily because there is no financial crisis brewing. In fact corporate balance sheets (outside of the energy sector), including those of financial services companies, are in decent shape. Additionally, despite slowdown fears, the U.S. economy, while not strong, is still growing by about 2 percent annually. That means in a year like 2015, you have soft quarters like Q1 and Q4 where there is barely any growth (+0.6 percent and estimated +1 percent) and the recession calls are abundant, and stronger ones like Q2 and Q3, where the economy seems fine (+3.9 percent and +2 percent).
Still, when people hear big banks, like RBS saying “The downside is crystallizing. Watch out. Sell (mostly) everything” it’s hard not to feel butterflies. Although some investors may be tempted to sell, they do so at their own peril. Market timing requires you to make two precise decisions: when to sell and then when to buy back in, something that is nearly impossible. After all, even if you sell and manage to steer clear of the bear by staying in cash, you will not be able to reinvest dividends and fixed-income payments at the bottom and you are likely to miss the eventual market recovery.
In fact, data from Dalbar confirm that when investors react, they generally make the wrong decision, which explains why the average investor has earned half of what they would have earned by buying and holding an S&P index fund. We’ll see if the folks at RBS can beat the odds.
The best way to avoid falling into the trap of letting your emotions dictate your investment decisions is to remember that you are a long-term investor and you do not have all of your eggs in one basket. Try to adhere to a diversified portfolio strategy, based on your goals, risk tolerance and time horizon and do not be reactive to short-term market conditions, because over the long term, this strategy works. It’s not easy to do, but sometimes the best action is NO ACTION.
If you are really freaked out about the movement in your portfolio, perhaps you came into this period with too much risk. If that’s the case, you may need to trim readjust your allocation. If you do make changes, be careful NOT to jump back into those riskier holdings after markets stabilize.
If you have cash that is on the sidelines and are nervous putting it to work as a lump sum, you should take heart in research from Vanguard, which shows that two-thirds of the time, investing a windfall immediately yields better returns than putting smaller, fixed dollars to work at regular intervals.
But, if you are the kind of investor who is less concerned with the probability of earning and more worried about losing a big chunk of money immediately, you may want to stick to dollar cost averaging. Vanguard notes “risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline.”