Mistakes to avoid amid the market downturn

06 March 2020 | Investing

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Following a decade-plus of generally rising markets, a meaningful downturn in stocks may finally be at hand. We don’t know how bad it will be or how long it will last.

We do know that some investors will make costly mistakes before prices rise again. Here are some common errors—and, for those who need them, some course corrections that should prove helpful over time.

Failing to have a plan

The first mistake in investing is doing so without a plan. It’s an error—often born of inertia or overconfidence—that invites other errors, such as chasing performance, market-timing, or reacting to market “noise.” Such temptations multiply amid downturns, as investors looking to protect their portfolios seek quick fixes.

Developing an investment plan needn’t be hard. You can start by answering a few key questions. Not inclined to make your own plan? Let a third-party financial advisor help you.

Fixating on “losses”

If you have a plan and a portfolio that’s balanced across asset classes and diversified within them, but the portfolio’s value drops significantly in a market swoon, don’t despair. Stock downturns are normal, and most investors will endure many of them.

Between 1980 and 2019, for example, there were eight bear markets in stocks (declines of 20% or more, lasting at least two months) and 13 corrections (declines of at least 10%1). Unless you sell, the number of shares you own won’t fall during a downturn. In fact, the number will grow if you reinvest your funds’ income and capital-gains distributions. And any market recovery should revive your portfolio, too.

Still stressed? You may need to reconsider the amount of risk in your portfolio. As shown in the chart below, stock-heavy portfolios historically have delivered higher returns, but capturing them has required greater tolerance for wide price swings.

The mix of assets defines the spectrum of returns

Expected long-term returns rise with higher stock allocations, but so does risk

The ranges of an investor’s returns tend to widen as more stocks are added to a portfolio. We examined the calendar-year returns between 1926 and 2019 for 11 hypothetical portfolios---book-ended by a 100-percent investment-grade bond portfolio and a 100-percent large-cap U.S. stock portfolio and including in between nine mixes of stocks and bonds, with each mix varying by 10 percentage points of stocks and bonds. The results include notably narrower bands of returns and fewer negative returns for bond-heavy portfolios but also smaller average returns.

Notes: Stocks are represented by the Standard & Poor’s 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg Barclays U.S. Long Credit AA Index from 1973 through 1975; and the Bloomberg Barclays U.S. Aggregate Bond Index thereafter. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard Investment Strategy Group. Data are as of December 31, 2019.

Overreacting or missing an opportunity

In times of falling asset prices, some investors overreact by selling riskier assets. They may join a “flight to quality”—moving to government securities or cash equivalents. Or they may embrace the familiar, perhaps moving from international to domestic markets, in a display of “home bias.”

It does sometimes take a market shock to alert investors to the risk in their allocations. For example, you may let your portfolio drift in rising markets, perhaps not realizing that you’re taking more and more risk over time. But it’s a mistake to sell risky assets amid market volatility in the belief that you’ll know when the time is right to move your money back to those assets. That’s called market-timing, and the chart below shows one reason why it’s a bad idea.

The futility of timing the stock market

Its best and worst days happen close together

During the past 40 years, thirteen of the 20 strongest daily gains for stocks, as measured by the Standard and Poor’s 500 Index, occurred in years that ended with negative total returns. And nine of the 20 biggest daily declines in stocks occurred in years that ended with positive total returns. Extreme market movements, up and down, often occurred in close proximity to one another.

Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Source: Vanguard.

Trading amid volatility? Consider the other side

A study based on 8.4 million Vanguard households whose account records are administered directly by Vanguard—perhaps the most comprehensive survey of household trading behavior ever published—did find heavier trading among investors in Vanguard IRAs, taxable accounts, and defined contribution plans during market-moving events. 2

While our research was based on U.S. investors, the study’s authors believe that research on non-U.S. investors would likely find similar trading behavior.

But not all Vanguard investors sold risky assets during or after the market downturns during our study period. Some went the other way—adding to their holdings of risky assets.

“Even during volatile periods, our study reminds us that there are always ‘two sides of the trade’—as some are selling, others are buying. It’s important for investors to realize this dynamic, especially those who may have strong feelings that ‘now’ is the time to sell,” said Stephen Utkus, Vanguard’s head of investor research.

Investors tend to trade more amid market-moving news

Monthly assets traded by Vanguard investor type, January 2011 to December 2018

Trading in Vanguard IRAs, taxable accounts, and defined-contribution retirement plans tended to be modest between 2011 and 2018. Specifically, an average of roughly one and a half percent of the assets in such accounts were traded in any given month. Trading spiked, however, amid such market-moving events as the European debt crisis of 2011, the 2016 U.S. elections, and market corrections. The highest monthly percentage of assets traded, which coincided with the debt crisis, was about three and a half percent. Trading was consistently higher among IRA and taxable account holders and lower among defined-contribution retirement plan investors.

Notes: The chart depicts trading by client account type. “DC” refers to defined contribution retirement plan investors. “DC crossover” refers to defined contribution retirement plan investors who also hold IRAs or taxable accounts with Vanguard.

Source: Vanguard.

What investors can do to insure against market downturns

It’s well and good to know what you should not do as an investor. What should investors do? Our counsel has not changed—and will not, no matter the markets’ course. At a high level, every investor should:

  1. Create or revisit investment goals, making sure they are appropriate;
  2. Develop suitable asset allocation using broadly diversified funds;
  3. Control cost; and
  4. Maintain perspective and long-term discipline.

The first three steps are integral to a good investment plan. The last step is required to enjoy the potential long-term benefits of that plan. Vanguard’s Principles for Investing Success provides a detailed primer on all four steps. For our research on these and other issues, see Vanguard’s framework for constructing globally diversified portfolios.

Rebalance

We believe you should periodically adjust your holdings to keep them in line with your target asset mix.

Getting back to your target mix, or rebalancing, sounds simple but often turns out to be hard psychologically. That’s because it requires selling assets that have performed better for you and buying those that have not done as well.

In market downturns, rebalancing may require investing in assets that have been losing value. “It violates our intuition,” Mr. Utkus said, “but either staying the course or buying more of the falling asset is the economically rational action.”

Think long-term

Investing is a long-term proposition, best-suited to the pursuit of long-term goals. Vanguard forecasts only modest gains for the ten-year period that started in the fourth quarter of 2019. We expect a globally diversified, 60% stock/40% bond portfolio to deliver annualized returns in the 3.5%–6.3% range, for example3. (For details, see our 2020 economic and financial market outlook, The New Age of Uncertainty.) Our investment strategists expect long-run gains despite an “elevated risk” of a large downturn in stocks along the way. But you have to remain an investor, even in the hard times, to maximize your chance of capturing the market’s long-term potential for growth.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM are derived from 10,000 simulations for each modeled asset class. Simulations are as of September 30, 2019. Results from the model may vary with each use and over time. For more information, please see the Notes section.

Notes:

All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Diversification does not ensure a profit or guarantee against a loss.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.

1 Source: Vanguard calculations, based on the performance of the MSCI World Index from January 1, 1980, through December 31, 1987, and the MSCI AC World Index thereafter. Both indexes are denominated in U.S. dollars. Our count of corrections excludes those that turned into bear markets. We count corrections that occur after a bear market has recovered from its trough, even if stock prices haven’t yet reached their previous peak.

2 Clark, Jeffrey W., Stephen P. Utkus, and Jean A. Young, 2019. Understanding household trading behavior 2011-2018. Valley Forge, Pa.: The Vanguard Group.

3 These potential outcomes for long-term investment returns are generated by the Vanguard Capital Markets Model® (VCMM) and reflect the collective perspective of our Investment Strategy Group. Return projections exclude the effects of investment costs, taxes, and inflation. The expected risk premiums—and the uncertainty surrounding those expectations—are among a number of qualitative and quantitative inputs used in Vanguard’s investment methodology and portfolio construction process.

Important information:

The views expressed in this material are based on the authors' assessment as of the first publication date (January 2020), are subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc. The authors may not necessarily update or supplement their views and opinions whether as a result of new information, changing circumstances, future events or otherwise.

This material is for informational purposes only. This material is not intended to be relied upon as research, investment, or tax advice and is not an implied or express recommendation, offer or solicitation to buy or sell any security or to adopt any particular investment or portfolio strategy. Any views and opinions expressed do not take into account the particular investment objectives, needs, restrictions and circumstances of a specific investor and, thus, should not be used as the basis of any specific investment recommendation. Please consult your financial and/or tax advisor for financial and/or tax information applicable to your specific situation.

In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its affiliates, including Vanguard Investments Canada Inc.

All investments, including those that seek to track indexes, are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market. While ETFs are designed to be as diversified as the original indexes they seek to track and can provide greater diversification than an individual investor may achieve independently, any given ETF may not be a diversified investment.

Investments in bonds are subject to call risk, credit risk, income risk and interest rate risk. Please see the Vanguard fund's prospectus for a description of the unique risks applicable to bond investing.

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