Investors have taken a beating. Year-to-date, the S&P 500 is down almost 20%. Worse, bonds are down about 10% over the same period. Aren't bonds supposed to provide stability and act as a hedge to stocks? Isn't that the whole point of the 60/40 portfolio?
As it stands, a retiree with a $1 million nest egg coming into this year has seen his account balance drop a staggering $160,000 ...
It would be tempting to stop the pain, sell everything, convert to cash, take a deep sigh, and start licking your wounds.
DON'T DO IT! Panic selling is not the answer.
Emotions in investing are a recipe for disaster. Everyone knows the goal of investing is "buy low, sell high." When you allow emotions to drive your investment decision, you inevitably do the exact opposite. As prices go up, you feel good, and in your exuberance, you buy more. As prices fall, you panic. The market is down 20%. Who's to say it won't drop another 20%??? Time to sell. Without fail, emotional investing results in nothing but regrets because you buy high and sell low.
But what if the market really does fall another 20%? Who's the fool now? Better to get out while you can, right?
Well, the market could drop another 20%, but it also could bounce back and gain 20%. If you could predict that accurately, you would have sold at the beginning of the year, before the first 20% decline ...
And therein lies the problem: you are your own worst enemy when it comes to investing. But you can change that by changing your perspective.
#1: Block out the noise
First, understand that the entire investing community is set up against you. The real-time tickers and account balances, the 24/7 financial "news" – it's all smoke and mirrors. It's all designed to play on your emotions to get you to click, read, and trade. It's noise. Step #1 is to block out the noise. Stop allowing other people to tell you how to think, feel, and act.
The reality is investing done right is really boring. And that's the problem for the investment community. How do you profit from boring? You don't. You profit from excitement and emotion. Don't be fooled.
#2: Flip the script–buy investments on sale
Second, investing is a win-win. When prices of your investments go up, you feel good (obviously). But here's the key: when prices fall, you can feel good, too, knowing that falling prices provide an opportunity to buy at a discount. Quality stocks are a great investment. Quality stocks selling at a discount are an even better investment! When the market falls, it's not time to sell. It's time to buy!
#3: Your account balance is NOT cash
Third, you didn't lose $160,000. What you lost is the opportunity to sell your investments for $160,000 more than what you could sell them for today. The only way you lose money in investing is when you sell an investment for less than what you originally paid for it.
This is important. Let's say your $1 million portfolio was built over an entire career, and your actual cost is $500,000. This year, the value of your portfolio has declined $160,000, leaving you with a balance of $840,000. Have you lost any money? No. Actually, you're still sitting on an unrealized gain of $340,000.
Now, if you're investments aren't held in a tax-advantaged retirement account, selling everything would result in a taxable gain of $340,000. You will owe tax on that gain, meaning you will have significantly less than $840,000 after you sell. Talk about rubbing salt in the wound.
#4: Cash is just as much an investment as stocks and bonds
Fourth, selling investments is simply converting to another asset class–in this case, cash. What's to say cash is a better investment going forward? Inflation is running at 8-10% currently. What happens to the "value" of your cash as inflation eats away at it? The only reason you feel more comfortable holding cash is because inflation is an invisible tax. If you saw the value of your dollars changing in real-time relative to the CPI and/or other currencies, you'd be just as panicked about the idea of holding onto such a volatile "investment".
Don't misunderstand: there's nothing wrong with holding some (or even significant) cash. Having cash gives the opportunity to act on #2 and buy as prices are declining. The point is you should hold cash as part of an investment strategy, not out of fear.
#5: Understand what you're giving up
Fifth, understand the trade-off. When you sell stocks and bonds, you forfeit your claim on future earnings and dividend payments. Bonds are paying about 3% right now. Stocks are yielding 5% and paying about 1.6% in annual dividends. If you sell, you're trading the 3-5% yield for money market or savings interest on cash, which is next to nothing currently.
More importantly, you need to determine your yield on cost. Remember, the cost of your investments (especially if you added to them over a long period of time) may be significantly less than the current market value. Let's use the same numbers from the example above. If the current blended cash yield (dividends and interest, excluding earnings stocks retain) of all the stocks and bonds in your $840,000 portfolio is about 2.16%, the annual income generated by your portfolio is about $18,000. That $18,000 is an effective 3.6% yield on your cost ($500,000), and that excludes stock earnings that will be used to buy back stock or reinvest to increase future revenue and profits, which will also benefit you as a shareholder.
If you sell, you forfeit $18,000/year of income and the benefits of future company earnings. Instead, you hold cash that generates almost no income and loses value to inflation.
#6: Real-time prices will drive you insane
Sixth, keeping up on investment prices in real-time is asinine. The value of Coca-Cola does not change 30% in one year. Yet it's stock price has fluctuated 30% over the past year. Amazon has bounced around 84% this year. Netflix stock has traded for as little as $162/share and as much as $700/share within the year! That's a range of 300%!
Do you own a home? If so, do you check Zillow daily or even hourly for your current Zestimate? Does the Zestimate even matter unless you're ready to sell your home? What if you check and the Zestimate of your home is down 20% this year? Is it time to sell your house?!
Do you own a business? Do you keep track of the value of your business daily, hourly, or even to the minute? Are you constantly thinking about whether it's time to sell your business?
If someone offered to buy your home or business for 20% less than what you thought it was worth, would you sell?
I hope your answer to all of the above is a resounding NO! Even if you don't own a home or business, I hope you can see how investment value doesn't change daily or hourly, nor should it matter to us what someone is willing to pay us for our investments today vs yesterday vs our best guess at tomorrow.
What's the solution?
The solution is to take a deep breath, block out the noise, and stick to an investment plan.
Like I said, investing done right is really boring. Come up with an allocation that works for you, like 60/40 stocks and bonds; invest using low-cost index funds; rebalance your account regularly. Rinse, repeat.
Don't buy or sell based on emotions, but based on your preestablished plan and rules. For example, rebalance quarterly or when one of your asset classes gets 10% or more out of balance. By rebalancing regularly, you will naturally buy low and sell high, and you will iron out the wild swings.
Even when stocks and bonds are both moving in the wrong direction and all hope seems to be lost, stay calm and rational. Look back at comparable periods in history to project how your plan will unfold. You can always consider a reallocation, but just as we tend to sell low and buy high, we tend to change allocation strategies when our current strategy has nowhere to go but up. I'd rather weather the storm and consider changes when times are good. Changing strategies in the middle of the storm is like trying to buy insurance when your house is on fire. If you don't have insurance when the fire is burning, it's too late.
Stay the course. You'll be glad you did. Then, the next time, it will be much easier.