Blue HavenMarket currents

How to think logically when you don’t know what will happen next

By April 19, 2020 No Comments

There is no graduating from the school of markets, it’s a life long education that teaches for as long as you choose to participate. Investors went through one of their most challenging “classes” ever last month, as stocks fell 35% in four weeks. We know now that that was the extent of the drop. Since then, stocks have staged a rally as historic as the decline, rising 30% in three short weeks. So what is the market going to do now? I wish I could tell you, but I have no idea.

How do you know what you should do then, when you don’t know what the market will do? You can start by answering the following question as honestly as you can: What will disappoint you more: selling some stocks, and watching the market continue higher, or not selling any stocks, and the market turns back lower? If it’s the former, you should consider reducing your stock exposure. If it’s the latter, sit tight and accept whatever bumps in the road you might encounter.

Think logically, not emotionally

Investment decisions and expectations for returns should always be driven by logic, not emotions. One of the ways to do this is to prepare yourself for multiple outcomes. Once you think through various scenarios, you can have a real conversation about how you might react to each particular one. For example, are you concerned that stocks could go back down to their March lows (23% down from here)? If so, the recent rally gives you an opportunity to lower your equity exposure. You could do this by raising a little cash or moving into a short-term treasury fund like VGSH or SHY.

Thinking this way helps you guard against emotional decision making. You’re able to think more logically when you have an understanding of your own emotional framework. That way, no matter what happens next, you can rationalize how you reacted. If you hold onto your stocks and they turn back down, remind yourself that that was the risk you accepted. You knew it was a possibility and you are (supposed to be) comfortable with it.

You can and should expand this scenario analyzer to then think about how you are likely to react to the consequences of your actions. For instance, if you don’t sell and stocks start sinking again, are you just going to bail out at lower prices anyway? Conversely, if you sell stocks and they continue higher, are you likely to FOMO chase back in at higher prices? Both responses would be emotional, not logical.

Where things get tricky

“Everyone has a plan until they get punched in the mouth.” This famous quote from legendary boxer Mike Tyson comes to mind after the way the market has traded in the last six weeks. You might think you’re comfortable with a drawdown in equities… until they experience their largest and fastest drop in history. So how do you account for the possibility that not only do you not know what will happen next but that it could be worse than even your worst-imagined scenario? For starters, consider your investments in the context of your total net worth and cash flow needs.

For example, a common discussion we had with clients over the last month is if they were nervous they would lose their job. If they were, we were forced to take a more cautious approach with their investments than we wanted. This is because not only did their investment portfolio decline in value, but they risked another portion of their wealth declining in value: their earnings from work.

Looking at the total picture

Take a hypothetical example where someone who makes $100,000 per year is confident their job is not in danger. Let’s give them a $100,000 investment portfolio which declined 25% in value during the market drawdown. If you combine their investment portfolio with their salary, they only lost 12.50% during the market drop ($25,000 is 12.50% of $200,000). However, if this same person is worried they might lose their job, they’re not just looking at $25,000 in losses from their investments but the possibility of an additional $100,000 in lost earnings.

Even if we assume that ~$40,000 of that can be made back in unemployment benefits (and/or possible severance), the loss on their net worth is way greater than just what they experienced in the stock market. Retirees, typically the most stressed about market gyrations, should consider how fixed payments like social security factor into their net worth.

March 2020 is not a template

Another thing investors must be conscious of is recency bias. That is the tendency to be swayed by recent information over historical trends. History tells us that the markets never before experienced a drop like the one they just endured in March. It was extremely rare and it may not happen again for decades. Keep in mind that the last time something similar happened was 1987 (30+ years ago). Prior to that, you’d have to go back to the 1930s (90 years ago!). In other words, the action in March is not a logical template from which we would recommend basing investment decisions on.

But what if a huge fast-paced drop does happen again, and sooner than anyone thinks? After all, we said ourselves we don’t know what will happen next. Well, again, if you are very concerned then you should take action now to reduce risk. Just don’t be upset if your concern costs you in terms of returns, because that is the risk you are taking. You’re giving up upside to protect against more downside.

The market’s bounce puts it down just 11% year-to-date. So you have a much better chance to rebalance your portfolio to include more conservative investments right now. You might consider AGG, which tends to perform well during market drawdowns (and has during this one). Or, you could look into buffered ETFs, which maintain equity exposure but offer some downside protection.

3000 is still new territory

The S&P 500 remains 18% from its all-time high. But provided you didn’t invest in the market for the very first time between November 2019-February 2020, you likely have investment exposure to the S&P 500 below the 3,000 level. In that case, the market is down less than 5%. To expand on that point, the S&P 500 has spent four months in its entire history above 3,000. The S&P 500 was created in March 1957. That’s 63 years ago, or 756 months. Therefore, statistically, the S&P 500 has spent just 0.50% of its entire life above 3000 (4/756=0.50%).

So, if you have a cost basis on the S&P 500 over 3000, you’re probably pretty young in your investment career. In that case, you have plenty of time to recover your losses plus add to your portfolio at lower prices. Or there’s the chance that you were simply unlucky over these last few months. To that, we would say if you invest long enough, chances are that luck will shift back in your favor.

Your own thought process

We’re not trying to minimize the ferocity of the market’s recent action. But we caution against being swayed to think it can help us determine what is likely to happen next. You can never make that determination. All we can be sure of is that if we want to be invested in stocks, we have to accept the risks that come with them. And if we’re uncomfortable with them, then we should make the necessary adjustments. Our thought process should be based on logic, not emotion. Better then preparing for what the market will do next, your best bet is to prepare for how you are likely to react. That way you can think logically today about what your emotions might be tomorrow.

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