Britta A. Keopf, CFP®
This blog post was adapted from a speech given at the 2017 Practical Financial Planning client appreciation dinner.
Not long ago, I heard the story of “the worst market timer.” This is a tale based on an analysis performed by financial writer Ben Carlson and written about in his blog A Wealth of Common Sense.
In 1970, 22-year-old Bob started his career and saved $2,000 per year. At the start of each decade, he increased his yearly contributions by $2,000.
At first, Bob saved his money under his mattress, but by the end of 1972, with all his friends telling him how fabulously their investments were performing, he takes his $6,000 and invests in a diversified stock mutual fund (sadly, the first index fund wasn’t created until 1975). Unfortunately, he invested at the peak of a bubble and from 1973 to 1974 the S&P 500 fell by 48%.
After seeing his hard-earned savings lose so much value, Bob decided not to invest any additional money in the stock market. He held to his convictions for fifteen more years until August 1987. Again, all his friends raved about how magnificently their stocks were performing. With the advent of index funds, he could invest the $46,000 he’d saved since 1973 in a nice low-cost stock index fund. Unfortunately, over the next two months, the market fell by over 30%.
In despair from his bad luck, Bob again swore he wouldn’t invest any of his future savings. While he didn’t hold to that conviction, he only invested two more times when all his friends told him stocks “couldn’t fail,” investing $68,000 in December 1999, and another $64,000 in October 2007. Both times, the market immediately fell.
After 42 years, Bob retired. He had invested a total of $184,000, which has grown to $1,100,000, His investment return over the course of his career was about 9%.
You may find this surprising given how much his investments had lost! But while Bob was extremely unlucky in the timing of his purchases, I disagree with the premise that he is “the worst market timer.” Bob may have only bought out of excitement, but he did not sell out of fear.
Sure, he would have been better off if his purchases were in 1974, 1988, 2002 and 2009, but he would have had to delay his retirement many years if he’d sold after the crashes. Retirement would be nearly out of the question if he never invested his savings at all!
If Bob came to us in late 2008 and lamented his terrible luck, I’d have told him that he shouldn’t look at how his portfolio performed over the past two years, but at the fantastic growth he achieved over the past 38 years.
The most basic investment advice is to buy low and sell high. But you don’t have to buy lowest and sell highest. All you need to do is buy lower and sell higher.
Had Bob come to us after the crash of 2008, we’d have given Bob advice that may not have been as lucrative, but it would have been the appropriate recommendation. Since he was entirely in stocks, we would have told him to diversify his investments into other asset classes, including bonds and cash. This would mean that he would sell when the market was down, but the trade would not come from a place of fear. We’d have given him similar advice if he had come to us at other points in his career.
Recent market performance or predictions of the future should not drive asset allocation. Our recommended allocation is based on your unique needs and your life situation, behavior, and goals.
This benefits you two ways. You need enough opportunity (along with the accompanying risk) to meet your goals without undue danger that a market downturn will interfere with your plans. Assuming your recommended allocation stays the same, every time we rebalance, we sell the investments that have grown the most and use the proceeds to purchase funds in the asset classes that have declined the most. By following this approach, over time we buy lower and sell higher.
Recently, we’ve heard some concern that the market is due for another downturn at any moment. I don’t doubt that we will have another crash; I just don’t know if it will start tomorrow or if it’s still twenty years out. (It may be interesting to note that I said as much when I first wrote this as a speech in November 2017. In the time between originally writing the speech and editing it in July 2019, the S&P 500 has had a net gain of about 15%).
In an investment class in college, we watched a PBS Frontline documentary, Betting on the Market. The film is about the dot-com bubble and the investment fad of the nineties. What’s notable about the film is that it aired in January 1997, a few years before the bubble burst.
If an investor had sold all their stocks in response to that show, they’d have missed the crash of the early 2000s, but they’d have also missed out on three of the S&P’s best years! Since that crash, there has only been one month where the S&P closed lower than it did January 31st of 1997. So, unless the investor got back in the market in September 2002, they would be worse off from anticipating the crash.
Had the same person instead hired a financial advisor using a passive approach, together they would have created an appropriately balanced portfolio and would rebalance every year. For each of the next few years, the advisor would recommend selling some of their stocks, locking in some growth. The year after the market started to fall, the advisor would recommend buying stock funds, which would by then cost less than they had the prior year. This would continue until the market started to go back up when they would again recommend selling some of the stock funds.
In reality, it’s unlikely that the recommended asset allocation would be static over 6 years. But, in general, by following their target asset allocation, the investor naturally buys stock lower than it will be and sells stock higher than it has been.
It can be very tempting to make trades based on the news. This is one of the benefits of hiring an advisor. My job isn’t to help my client beat the market. What I do is better: I help my clients avoid emotional reactions to market performance and blog posts, which actually tell us nothing about what’s about to happen in investment markets, and instead make investment choices based on logic and research.