Swedroe: Don’t Sell During Volatility

September 25, 2015

As I observe in my book, “Think, Act, and Invest Like Warren Buffett,” one of the great anomalies in investing is that while investors idolize Warren Buffett, they tend to ignore his advice, especially when it comes to efforts to time the market.

The following are just a few of his many “words of wisdom” on the subject of what is most often referred to as tactical asset allocation (TAA):

  • In Berkshire Hathaway’s 1991 annual report, he warned against trying to time the market: “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
  • In a June 1995 interview with BusinessWeek, Buffett asserted: “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.”
  • In Berkshire Hathaway’s 1996 annual report, he offered these words of sage advice: “Inactivity strikes us as intelligent behavior.”

Tough To Fight Human Nature

I know it can be hard for investors to hear that the best choice of action is to stay the course, even during tough times for the market (like those we experienced in August and September). Keeping your head—especially on days such as Aug. 24, when the Dow Jones industrial average fell 1,089 points in a loss larger than the “flash crash” of May 2010—while many around you appear to be losing theirs is extremely difficult. It can be even harder to hear the message to stay the course, repeatedly, as things move from bad to worse.

But, as my colleague, Carl Richards, noted, following the herd is something done by sheep, not smart investors.

Thanks to Wes Wellington of Dimensional Fund Advisors, we have some further evidence that demonstrates the wisdom of Warren Buffett’s advice. Wellington noted that the S&P 500 had declined 10 percent or more on 28 occasions between January 1926 and June 2015. Of course, every plunge of an even greater magnitude began with a 10 percent market decline. And that tempts many investors to believe that avoiding large losses can easily be accomplished by eliminating equity exposure entirely once that 10 percent threshold has been breached.

Panic Caused By Overconfidence

In addition, many investors panic (abandoning their long-term plans, if they have them) and sell. This often occurs because overconfidence has led them to take more risk than their stomachs could safely handle. As Wellington aptly states, “Market timing is a seductive strategy. If we could sell stocks prior to a substantial decline and hold cash instead, our long-run returns could be exponentially higher.”

Unfortunately, for market timing to work, investors have to be right twice, not just once. You not only have to sell at the right time, you also have to decide when it is again safe to buy, thus running the risk of missing out on the next rally. Wellington found that for the period January 1926 through June 2015, returns to the S&P 500 after drops of 10 percent were, on average, 23.6 percent, 8.9 percent and 13.3 percent over the next one, three and five years, respectively.

The evidence from both international and emerging markets was very similar. For the period January 2001 through June 2015, returns over the next one, three and five years for large-cap stocks in developed international markets following periods of 10 percent losses were 24.7 percent, 12.7 percent and 12.9 percent, respectively.

For the period January 1999 through June 2015, returns to emerging market stocks over the next one, three and five years following 10 percent losses were an even more impressive 42.2 percent, 13.4 percent and 11.2 percent, respectively.

‘Difficult Hurdle’

In case you might happen to believe that professional investors fare better than individuals at timing the market, consider the evidence from a study by Vanguard that appeared in the spring/summer 2009 issue of Vanguard Investment Perspectives.

The study, which defined a bear market as a loss of at least 10 percent, covered the period 1970 through 2008. This period included seven bear markets in the United States and six in Europe.

After adjusting for risk (exposure to different asset classes), Vanguard concluded that “whether an active manager is operating in a bear market, a bull market that precedes or follows it, or across longer-term market cycles, the combination of cost, security selection, and market-timing proves a difficult hurdle to overcome.”

Vanguard also confirmed that past success in overcoming this hurdle does not ensure future success. It was able to reach this conclusion despite the fact that the data were tilted in favor of active managers because it contained survivorship bias.

Market Timing Follies

This type of evidence is why Warren Buffett admonishes investors against market-timing efforts. It also explains why John Bogle, founder of Vanguard, warned against trying to time the market.

In his book, “Common Sense on Mutual Funds,” Bogle stated: “After nearly fifty years in this business, I do not know of anybody who has done it [market timing] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.

But perhaps legendary investor Bernard Baruch said it best: “Only liars manage to always be out during bad times and in during good times.”

Pay Attention To The Evidence

While it’s only human to be concerned with recent market volatility, you’re best served by developing a well-thought-out investment plan that reflects your need, ability and willingness to take risk, and then sticking to it.

While this approach can be challenging to maintain during periods of high market volatility, the evidence clearly shows that it is the surest path to achieving your financial goals.

And remember, it’s what Warren Buffett recommends you do. Thus, unless you’re convinced you are smarter than he is (in which case you’re likely overconfident, an all-too-human trait), you’re best served by following his advice.


Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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