Recent market volatility is a sign that many have learned the wrong lessons from the global financial crisis and the dot-com bust.
Extremes of fear and greed are apparent, as investors repeat self-destructive behaviors. The “fear of missing out” helped drive January’s unsustainably strong surge in U.S. equities, with retail investors boosting their participation in the market. Fear of missing out was particularly high for investors who have paid the “opportunity cost” of missing some or all of the market rally since 2009.
The interest in bitcoin and other cryptocurrencies is another example of a rising speculative element to investor behavior. January’s gains were erased in a few turbulent days in early February, as fears of rising inflation and interest rates contributed to the first market correction since 2016. The abrupt shift in market sentiment in early February is a reminder that scars from the dot-com bust and global financial crisis remain.
[See: 8 Ways to Buffer Your Portfolio From a Market Slide.]
Rapid market swings provide an indication that investors haven’t been cured of the temptation to time the markets. However, “time in the market” has been a far more effective strategy than trying to time the market. Market timing, however tempting, doesn’t work. Considerable evidence supports the conclusion that market timing is a recipe for failure. Morningstar has an annual study that shows the impact over a 20-year period of missing the 10 best days in the market. The results are stunning, and tell a consistent story. For the 20-year period through the end of 2016, missing the 10 best days in the market reduced annualized returns from 7.7 percent per year to 4 percent per year.
Yes, annualized returns would improve for investors able to avoid the 10 worst days in the market. Unfortunately, the best and worst days in the market are often clustered together, as was the case in early February. Although a few investors have experienced temporary success and fame from calling a major turn in the market, it is nearly impossible to find investors with a track record of repeated success in calling major market moves. In many cases, high-profile success is followed by failure. John Paulson and Meredith Whitney are among the long list of investors who have experienced adversity in trying to find success in their second act after a reputation-making market call.
February’s correction was magnified by the unwinding of significant bets on low volatility strategies. The spike in volatility and collapse of some low volatility products is a painful reminder of Warren Buffet’s adage: “Only when the tide goes out do you discover who’s been swimming naked.” A common investment misconception equates risk to volatility, reinforcing the behavioral bias of loss aversion. Although volatility is emotionally challenging, the primary risk for investors is that of a permanent loss of capital. An important lesson to be learned from the dot-com bust and global financial crisis is that most causes of permanent loss of capital are self-inflicted.
[See: Warren Buffett’s 8 Favorite Stocks.]
Many investors who failed to diversify their portfolios suffered during both bear markets. Employees with portfolios that were concentrated in the stock of their own company were among the hardest hit, particularly employees of companies that encouraged them to invest their 401(k) in company stock. Employees at companies such as Enron and WorldCom lost their jobs and 401(k) nest egg at the same time. Some investors during the dot-com bubble thought they had well-diversified stock portfolios because they owned multiple technology stocks. When the dot-com bubble burst, portfolios with excessive concentration in technology were harder hit than portfolios that had sector diversification. The lesson to be learned is the importance of portfolio diversification.
Another important lesson is the need to maintain enough liquidity to meet anticipated expenses, and an emergency fund for unexpected expenses. Investors with an insufficient liquidity cushion can become forced sellers at inopportune times.
Being a forced seller was particularly punishing in 2000 and 2008, creating “no-win” situations for investors who preferred to avoid selling assets expected to rebound from depressed levels. Investors can also be forced sellers when a third party forces a sale at an inopportune time, typically when the investor has pledged collateral to secure a loan. Many real estate owners found themselves in this position after the real estate market crashed in 2008, owning an illiquid asset with falling market value and fixed carrying costs.
Similarly, investors who borrowed on margin to buy stocks faced margin calls during the dot-com bust and the global financial crisis.
The third self-inflicted cause of permanent loss of capital is forcing oneself to sell because of the emotional stress associated with volatile markets. Avoiding panic-related selling is one of the most important lessons to heed, and provides another argument in favor of maintaining a moderate intake of financial news.
Extreme points of view tend to get a lot of attention during the late stages of a bull market. Commentators who proclaim that “this time is different” project that tax cuts, infrastructure spending and deregulation will create a return to Reagan-era economic growth without an increase in interest rates or the federal budget deficit. On the other end of the spectrum, some commentators promote a doomsday scenario in which the U.S. dollar collapses, inflation returns to 1970s levels and the stock market experiences a collapse worse than the global financial crisis.
A quote from legendary investor Mark Mobius provides an appropriate level of skepticism: “People who think they know all the answers probably don’t even know the questions.”
[See: 10 Stocks Already in a Bear Market.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.
More from U.S. News
7 of the Best Stocks to Buy for 2018
20 Awesome Dividend Stocks for Guaranteed Income
The Top 10 Investment Portfolio for Millennials
Did We Learn From the Global Financial Crisis and Dot-Com Bust? originally appeared on usnews.com
