The Stock Market Bear’s Have Come to Play, But Don’t Leave the Playground

My savings have taken a hit over the last week, and if your savings are invested to any extent in the world stock markets so have yours. You may be feeling like the family in this video, a little helpless. The S&P 500 officially entered correction territory today, having fallen just over 10% from its May peak. Now that I’m living off my savings, am I worried? No. Am I going to do anything? No.

That is because I have several years worth of expected spending in relatively safe investments. These safer investments are money market mutual funds and short term bond exchange traded funds (ETFs). Therefore, I do not have to worry about selling my stock market investments in this down market. I have the luxury of waiting for it to recover. Yes, I have paid a price for this security. The return on these safer investments is low, ranging from nearly nothing on the money market funds to about 1.75% on the short term bond ETFs. But they keep my stock market losses, paper losses.

If you are like most people, your stock market investments live in your employer sponsored retirement plan. That means you won’t be relying on your stock market investments for spending money either. Should you make any changes? No. Your retirement account is a long term investment, and if you have more than ten years before you begin living off your retirement investments, there is no reason you shouldn’t be invested in the stock market.

It is true that if you can avoid the downturns in the market your investment return over time will be much better than if you stay in the market. The trouble is no one can reliably avoid the downturns. Selling your stock market investments to avoid a further loss will generally ensure that you incur much of the downturn and that you miss much of the recovery. It isn’t only the average individual investor who makes these mistakes. About a year ago, I did some research on a category of mutual fund called tactical allocation funds (tactical). In these funds, the fund manager attempts to avoid market losses by selling stock market investments to avoid a market downturn and increasing stock market investments when he or she believes the market will turn up.

I compared the tactical fund results to that of moderate allocation funds (often called balanced funds). Balanced funds have similar target allocations to stock markets as tactical funds, about 60% of the investments, but have a much narrower range of allocations. The amount of change the balanced fund managers made in their stock market allocations was less than 15% over three year periods, but the amount of change in stock market allocations made by tactical managers was over 40%. Did it improve returns? No.

Less than 1 in 10 of the tactical managers had better returns than the average balanced manager over a ten year period, and less than 1 in 4 had better returns over a five year period. During the financial crisis of 2008 and 2009, no tactical manager performed better than the average balanced manager in both years. About half the tactical managers performed better than the average balanced manager over the two years combined, but so did about half of the balanced managers. My conclusion from this study was that even professional managers charging a fee to protect you from market downturns cannot reliably beat holding your stock market investments through the downturns and the up turns.

As I listened to the news this morning, the news correspondents were asking “what should the average investor do?” I never heard an answer from the pundits more specific than “It depends”. Here is my advice. Do nothing! The market on average is down one in every four 12 month periods, but it has never failed to recover. Even the professionals aren’t very good at timing the market ups and downs. Insure your investments by keeping the money you need to spend in the next few years in relatively safe investments like money market funds and short term bonds, and don’t worry about the stock market ups and downs in the mean time.

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