The quick and robust stock market recovery during the first quarter of 2019 brought relief to investors, who once again turned to focus on positive returns. The rapid turnaround certainly changed the tenor of reporting in the financial press.
But as quickly as we have moved forward, it’s a great time to review one of the pillars of disciplined investing — staying the course. This recent period of returns provided an excellent example of the rewards of staying the course as a disciplined investor. It also showed how challenging and costly it can be to the average investor who overrides discipline and changes their portfolio via market timing.
As 2018 presented several painful months, the average investor took money out of the stock market. Although such a move is intended (we assume) to improve performance, Dalbar calculates that while the S&P 500 lost 4.38% for 2018, the average investor lost 9.42%, roughly twice the amount that maintaining an investment in the S&P 500 would have yielded.1 This alone shows just how difficult it is for the average investor to improve returns with opportunistic trading. It turns out that such trades are emotional and are rarely made in advance. They usually lag poorer performance, locking in those losses.
Takeaways From Down Markets
There is something to be learned in down markets, though. If it’s too uncomfortable for an investor to stay the course in down markets, they may find that their portfolio risk tolerance is too aggressive. They should review this tolerance to come up with a long-term plan that better matches their true risk tolerance.
The other issue raised with down markets is that of financial planning. If an investor set their risk tolerance as a long-term investor, but they have short-term goals or financial needs, they need to consider those. You may be planning to buy a house within a year and need liquidity for a down payment. Or you may have a child entering college. The need for this kind of liquidity can be met with financial planning while leaving a long-term plan in place for the rest of your investable assets.
The Consequences of Active Trading
The recent period is of particular interest for reviewing the difference in an investor who stays the course and an investor who does not. In this case, the market experienced a sharp and fairly immediate upturn beginning in January 2019 and holding through the first quarter. The S&P 500 returned 8.01% in January 2019 and 13.65% for the first quarter.2 In fact, all major asset classes experienced positive returns in this time period, including fixed income.
This highlights the double cost of having sold all or part of your market position. While it’s one decision to have sold assets from the market, an equally important consideration is re-investing those assets back in the asset class. You have not one but two chances to get this decision wrong and miss market opportunities. And indeed, an investor who changed their position in 2018 and sold out of an equity position (still losing more than the market on average based on the Dalbar study), now also misses out on the positive return in the first quarter by being out of the market. The investor who stayed the course earned the rewards of the rising market in early 2019. This is how disciplined investing pays off.
There is another, often overlooked cost of actively trading your portfolio. You guessed it — taxes. Every time you trade in and out of securities, you create a tax implication by creating a capital gain or loss. If you think you are talented at this and will generate gains, and if you trade often, you are likely not holding your positions for longer than a year. So any gains are short-term gains, and you will be taxed up to 40%! In fact, in order to beat the buy-and-hold investor, you don’t just have to equal the market, you have to do substantially better to outperform the benchmark after taxes.
Staying the Course
The S&P 500 is probably a more concentrated investment than a savvier investor would choose. So what happened when a hypothetical investor chose to move from a 60/40 (equity/bond) balanced exposure to a 20/80 balanced exposure? This is a more conservative change than completely selling out an S&P 500 position, which created a large impact. In this case the investor made the change away from staying the course on December 31, 2018, after experiencing the negative returns and remained out of the market through April 18, 2019. (Note that there is nothing special about April 18. It just happens to be the date we were collecting data for this example.) If the investor had a portfolio with a value of $1 million on December 1, 2018, this move to shift market exposure to 20/80 cost the portfolio $49,717 in that short period of time.
Now imagine if you do this repeatedly over your history of investing. Your portfolio experiences these losses more often. Also, this loss isn’t static. It turns out it’s magnified by compounding returns over the life of your savings. So the cost can be quite significant to your long-term portfolio value.
So how does one learn to stay more disciplined? It helps to know that research continues to show that investors who stay the course earn a better long-term return. And it is certainly easier when you have good financial planning in place for short-term cash flow needs. Having an advisor who reviews each situation and confirms when staying the course remains the best approach can create this discipline for you, helping you increase your confidence in staying the course.
As you experience more of the difficult markets and see the positive returns that follow, you will have more experiences that support how such a disciplined approach works. And this will help you avoid the whiplash that so many investors experienced over the last year.
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Source for all return data: ©  Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.