March 18, 2021James Smerke

Down Markets Hurt...Staying Invested is Key

The field of behavioral finance is brand new compared to the history of the financial markets, only really taking off in the 1990s with important work by Nobel Prize winning economists such as Robert Shiller, Daniel Kahneman and Richard Thaler. What we have to know is that emotional decision making is at the heart of human nature. As we’ve learned, human biases are interwoven into our financial decision making as well and can have dramatic outcomes on portfolios over time.

Loss aversion, just one of those biases, can derail even the most well-intentioned investors from staying the course and achieving their long-term goals in the face of market volatility. At its core, loss aversion is the tendency of investors to prioritize avoiding losses over earning gains in the market. One interpretation of this behavioral tendency would conclude that negative sentiment impacting the market to the downside has a good chance of causing investors to make irrational decisions such as trying to “market time”, or to move out and into the market at times that they believe to be at nearly the correct peaks and troughs of a market swing. As we enter the year of vaccinations, we can look to a recent analysis of 2020 and years prior to better understand why this bias can be detrimental to a long-term investing time horizon.

We can see this illustrated below via analysis from J.P.Morgan Asset Management. Looking at daily returns in the S&P500 index during 2020, they calculated that 7 of the best 10 days of returns occurred within two weeks of the 10 worst days and 6 of those 7 best days occurred AFTER the worst days. The second worst day of the year, March 12th, (as COVID began its grip on the world and the market plunged into recession) was followed by the second best day of the entire year on March 13th. (-9.51% and +9.29% respectively)

Expanding our timeframe by looking at historical returns in the S&P500 index over the past 20 years, we can see the long- term effects on a portfolio that market timing has the potential to cause. Missing just the 10 best days of performance over this period, (~5,000 trading days over the course of 20 years) annualized investment returns were reduced by more than half from the return generated by remaining fully invested in the market. Even more eye popping is that the return turned negative (-1.49%) after missing out on just 30 of the best days of performance during the 20 year time period.

Source: J.P.Morgan Asset Management, Guide to Retirement, March 14, 2021

Last year alone, there were several instances where volatility spiked, markets retreated, and investors could have strayed from their well diversified long term portfolio allocations for the perceived protection against further losses. If an investor was able to time the initial COVID market sell-off, when would they have bought back in? Would that same investor have sold again during periods in September and October in which we saw the S&P500 correct -9.6% and -7.48% respectively on fall virus surge worries, or again just in the last few weeks as the market (specifically growth and long duration assets) struggled with inflation worries from a fresh round of $1.9T in fiscal stimulus, a reopening economic comeback story, and a historically high M2 supply? Not only would that investor be risking performance as we see in the data, but also dabbling in a highly tax inefficient strategy. This is all in the context of a market in which the S&P500 index ended up setting 33 record closing highs during 2020.

Source: Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS, March 14, 2021.

While past outcomes are not a determinant of what the market will do moving into the future, we can say with certainty that increased volatility stemming from the movement in interest rates is here to stay for the time being. Market pullbacks of 5-10% within the context of a longer-term secular bull market should be expected. Wellspring will continue to advocate for well diversified, all-weather portfolios built around optimized risk budgets to navigate the volatility, stay the course, and meet our families planning goals now and for the long term.