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By Cory Clark
Special to the Financial Independence Hub
Nobody knows if we have reached the turning point in the year’s pandemic-induced market meltdown. The markets are not quite as scary as they were at the beginning of March when some markets lost nearly 20% of their value in a single day.
Some recoveries are rather swift, while others take a little more time, but there is one way to know when the market has reached its bottom … just kidding …. there is no way of knowing, and that’s exactly why the average investor should not be bailing out of their positions when storm seas get rough.
If you decide that you can’t stand the risk of loss and fear that goes along with it, the only way to sell and successfully mitigate losses is to make two correctly timed decisions. Not only must you sell at the right time, but you must also re-enter at the right time. DALBAR has been studying investor behavior since 1994, and it is painfully obvious from history that investors are not going 2-0 and timing it right on both ends.
The common rationalization for selling out at the worst time is that if you are not losing money, you must be better off, right? This an example of a dangerous investor behavior known as risk aversion, and from an economic standpoint it is an invisible hole in the bottom of your bucket. Investors love to make money, but they hate to lose that same amount of money even more. So being out of the market and avoiding a loss provides a measure of comfort, but being out of the market and losing out on a similarly sized gain tends to go unnoticed. But when looking at your investor statement, or when projecting future retirement income, money you lose and money you should have (but didn’t) gain will all have the same net effect on that bottom line.
Don’t get out if you don’t know when to get back in
The situation of today’s average investor perfectly illustrates in live action what DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has been teaching investors and advisors for years; don’t get out if you don’t know when to get back in.
Imagine an investor who reached their breaking point sometime in March, and sold their equity position with the intention of buying back in when the coast is clear. Not long after, the markets started to shoot back up aggressively, much earlier than anticipated. Now doesn’t that put this investor in a precarious situation? Who wants to be “that guy” (or gal) who buys back into the market after the biggest daily gain ever? If the recovery ends up being a false start, this investor could lose a significant chunk of his portfolio … AGAIN. So perhaps this investor doesn’t fall for a potential false bottom and continues to wait …. and wait … and wait … until the recovery is certain. Unfortunately, by the time the recovery is certain, it’s over and this investor has missed the boat.
As it turns out, investors simply don’t experience FOMO (Fear of Missing Out) as much as they experience FOLO (fear of losing out). Consequently, the fear of losing lingers far beyond the crisis period and investors are left worse off than if they had done nothing at all. For those investors who sold during the last month, it is important that they get back into the market and not engage in the destructive speculation described above. But is it safe to get back in? If I knew the answer to questions like that, I would be on a remote island somewhere, sipping on a pina-colada. So while there is no way of predicting the future, there is a way to conquer the fear of losing money without the risk of missing out.
Institutional hedging strategies
To do so, one must look to some basic institutional hedging strategies that are largely unknown to the average investor. These hedging strategies can set a limit on further losses while allowing the investor to fully participate in the market recovery. This should clear the way mentally for many investors to get back into the equity markets. The hedging strategy that underlies DALBAR’s Investor Panic Relief Tool (DALBAR i-PRT) is the index put. The index put is a bet against a particular index, meaning when the index goes down, you make money that more than offsets the losses from the decline. If the index goes up, the investor participates in that advance, less the cost of the index put. It’s just like phone insurance only for your portfolio.
The cost of the index put (typically around 1% of the portfolio being protected) is the insurance premium, that relatively painless amount of money that you part with upfront so you don’t have to tie your phone to your wrist. If the index goes down the toilet, just like when you drop your phone in the toilet, your insurance premium protects you from losing out. If the market goes up and you are unharmed, just like if your phone was lucky enough to stay intact, you lose the cost of the insurance premium but gained the peace of mind throughout that time period.
So if you are sitting on the sidelines, watching the markets possibly recover, ask yourself, is your phone more important than your portfolio?
Cory Clark is Chief Marketing Officer at DALBAR, Inc. Over the years, Cory has worked with retirement plan specialists, investment managers, advisors, broker/dealers and insurance companies to optimize their communications, compliance and business practices. Cory is also a licensed attorney in Massachusetts, where he resides with his wife and 3 children.
