Swedroe: No Safety Flags In Investing

January 03, 2019

In case the latest bout of stock market volatility, which I explored earlier this week in a pair of articles about putting market moves in perspective and the danger of market myopia, is tempting you to sell now and wait for safer times, remember that to benefit from market timing you have to be right twice, not once. I hope the following explanation helps you to decide on the right strategy.

If you go to the beach to ride the waves and you want to know if it’s safe, you simply look to the lifeguard stand. If the flag is green, it’s safe. If it’s red, the ride might be fun, but it’s also too dangerous to take a chance. For many investors today, the market looks too dangerous. So, they don’t want to buy, or they decide to sell.

Here’s the problem. While the surfer can wait a day or two for the ocean to calm down, there is never a green flag that will let you know that it’s safe to invest. You might think that is the case (as many investors did in the late 1990s), but it never is.

Recall the litany of problems the markets faced from March 9, 2009 (when the bear market ended) all the way through 2017. There was never a green flag letting you know it was safe. It was red the entire time.

And for much of that period (2013 onward), you had highly regarded market gurus such as Jeremy Grantham warning that the market was massively overvalued. Yet the market ignored those warnings and provided returns well above the historical average.

Conjuring Green Flags?

So, if you decide to sell, you are virtually doomed to fail as you wait for the next green flag. Even worse is what happened to some investors who only thought they saw a green flag.

Consider an investor who, after watching the S&P 500 Index crash from about 1,450 in February 2007 all the way to 752 on Nov. 20, 2008, finally throws in the towel. He cannot take the losses any longer. He is worn out by the wave of bad news. So, he decides to sell.

However, he knows there is a problem. With interest rates at their current level, there was no way he could achieve his financial goals without taking risks. And he certainly does not want to buy riskier fixed-income investments (such as high-yield corporate bonds, preferred stocks or emerging market bonds), having watched how poorly they were performing.

The mistake of confusing yield with return is one he was not going to make. Thus, he designs a strategy to get back in. He will wait until next year to see if the market recovers.

By Jan. 6, 2009, the S&P 500 had risen almost 25% to 935. Of course, he had missed that rally while he waited for that green flag. But now he feels it’s once again safe to buy. Unfortunately, by March 9, 2009, the market had dropped back all the way to 677. So, now he sells again. How likely do you think it is that he would ever find the courage to buy again? That is the essence of the problem.

Additional Data

Here’s some further evidence that might help you avoid panicked selling. As mentioned in my earlier article, there have been only two months in the last 78 years when the S&P 500 Index fell more than 15%—October 1987’s loss of 21.5% and October 2008’s loss of 16.8%.

How did the market perform after those losses? While November 1987 tested investors with a further loss of 8.2%, the following 12-month return (November through October) was 14.7%. And while November 2008 also tested investors with a further loss of 7.2%, the following 12-month return was 9.8%.

Over the last 78 years, we have also experienced four quarters in which the S&P 500 lost more than the 20%—the four quarters ending September 1974 (-25.2%), December 1987 (-22.6%), December 2008 (-21.9%) and June 1962 (-20.6%).

Over the next 12 months, returns ranged from 17% to 38% (averaging 28%); over the next 36 months, returns ranged from 49% to 73% (averaging 60%); and over the next 60 months, returns ranged from 95% to 128% (averaging 112%).

Let’s try to summarize what we have learned.

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