Investing in the stock market is not for the faint of heart. Sure, everyone feels smart and like a great investor during a bull market, but what do you do when 2009 repeats itself? When the market punches you in the gut with a 54% decline from its peak causing you to lose half of your hard earned money. Here is my strategy on how to cope with market volatility.
Historic Market Volatility in Graphs
Below is a graph of the S&P 500 from 1977 to 2019. You will see the clear trend that it has risen over time with spikes in volatility. Over this approximate 41-year time frame the market has provided an annualized return with dividends reinvested of approximately 11.6%. I used this website for that handy piece of information.
You will obviously notice the huge down turns around the years 2000 and 2009. Some people will panic and sell their stocks at this time. The rationale is “look at how much money I lost, I can’t lose any more, stop this craziness! Let me sell now and I never invest in stocks again.” Well, look what happened after the down turns. That’s right, huge returns followed. Selling at the bottom of these downturns is exactly what you should not do. And if you think this up/down see saw is only in the past 40 years, think again. Look at the below graph from 1927 to 1977 showing similar ups and downs.
Everything is on Sale!
My wife, who is not interested in financial markets, knows that whenever she sees headlines of the market going down, I will be in a good mood. This really made her scratch her head at first, thinking I would be upset about losing money. But she has learned over the years the method to my madness. Here is my analogy. Say you are contemplating buying a big screen TV with all the latest fancy technology, but you can’t justify paying such a high price. Then, it goes on sale. Down 10%, 20%, even 50%. You couldn’t be happier. Then why are people upset when stocks go down? They are not down, they are on sale!
Most will counter that analogy with all the money they lost in their portfolio despite being able to buy things cheaper. But remember, you will not need your retirement savings for a long time and the downturn as shown above is temporary. Even when you are at the age of 70 you will slowly withdrawn funds at say 4% a year, still leaving a long investment horizon.
A Story from Mr. Buffet
I will let Warren Buffet explain how he views market volatility. He purchased a 400-acre farm, 50 miles north of Omaha, for $280,000 in 1986. He says he calculated the farm’s return at the time to be about 10 percent, based on production estimates for soy and corn. The farm is worth about five times what Buffett paid, and earnings have tripled.
He compared daily fluctuations in stock values to an erratic farm neighbor standing near his property, yelling out offers for the land.
If a moody fellow with a farm bordering my property yelled out a price every day to me at which he would either buy my farm or sell me his — and those prices varied widely over short periods of time depending on his mental state – how in the world could I be other than benefited,” Buffett wrote. “If his daily shout-out was ridiculously low, and I had some spare cash, I would buy his farm. If the number he yelled was absurdly high, I could either sell to him or just go on farming.”
But that’s not how equity holders often react, Buffett said.
Owners of stocks, however, too often let the capricious and irrational behavior of their fellow owners cause them to behave irrationally,” he wrote. “Because there is so much chatter about markets, the economy, interest rates, price behavior of stocks, etc., some investors believe it is important to listen to pundits — and, worse yet, important to consider acting upon their comments.”
Did you Catch That?
I started by saying you should ignore market downturns. Buffet in his financial genius is saying you should use them to your advantage. When the market is screaming at you saying things are on sale, you are free to do nothing or use any spare cash to buy more. Instead of panicking during market downturns they can be viewed as an incredible opportunity to buy more.
The Two Account Method
Even though we know that selling when the market is going down is the worst thing you can do, I can still understand people being scared. I’m the same way, seeing my investments go down in 2009 made me sick to my stomach. After all the books I’ve read and years of experience, what do I propose to cope with market volatility? Simple, don’t look :-). To help, I now have two brokerage accounts. One where I do all my direct deposits, bill pay, and any active trading which is mostly investing cash in short term treasuries. I also keep another account, let’s call it my set it and forget it account (“SI&FI”), where I do my index investing. I view it as my mattress money, but better. Instead of the money just sitting under my mattress, it’s compounding over a long investment period.
In an effort to deter me from looking, my SI&FI account password is impossible to remember. I can’t even remotely guess what it is. Going one step further, I wrote down my password in a hard to access place, making it quite the chore to login into my account. Accessing nuclear codes for the president may be easier than getting into my account, not quite, but you get the point.
Next, I have my SI&FI account set up that it automatically pulls from my direct deposit account every month and invest in my predetermined allocation. No matter what the market is doing, I automatically invest on a consistent monthly basis. If the market goes up, I am happy that I made money on my investments. If it goes down, I am happy to buy things on sale.
Reasons to Look at Your Hidden “Mattress Money” Account
There are potentially three reasons to look at your SI&FI account, but in no way required. You can ideally go years without having to look.
First, is once a year you may want to re-balance your account. Re-balancing is a method of reallocating money to your desired asset allocation mix. It’s not critical to re-balance but could offer some additional return over a long time period.
Let’s say that your asset allocation is 60% US stocks, 30% Non-US stocks, and 10% bonds. If the US stock market is outperforming the Non-US and Bonds, you would sell some of the US index which should be a higher valuation since it has gone up in price more relatively to the other two. With the sale proceeds you would buy some Non-US and Bond indices. In effect you are moving money from more expensive investments to cheaper ones. For example, your allocation at the end of the year is 63% US, 28% Non-US and 9% bonds. You would sell 3% of the US and buy 2% Non-US and 1% Bonds bringing the allocation back to 60/30/10.
Another reason to re-balance is Buffet’s 90-10 asset allocation for his wife, with a twist. It offers a unique perspective on how people perceive risk in stocks vs bonds. If re-balancing seems too much of a chore, vanguard offers a fund that does it for you, such as the VBIAX. It follows the popular 60% stock and 40% bond split.
A second reason to look at your account is to set up or change withdrawals for the years during retirement. You can also do this when re-balancing thus only looking at your account once. Or you can set up automatic distributions through many of the popular brokerage houses.
The third reason that you would look at your SI&FI account is to invest more when stocks are down. This would cause you to see how much you lost, so I only recommend it if you have the temperament to buy more. At the end of December 2018 when the market fell 20% from its peak, I was logging into my SI&FI account every day to buy more stock index. Everyone thought I was nuts around the holidays when they were concerned about their 401ks being down and I was so excited to invest more money. Fair warning, you may get some dirty looks when you show so much excitement when others are so down.
Warren Buffet on Temperament
Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
Why People get Back into the Market after Selling
Remember the earlier example where people sell because they lost so much money? They claimed to never invest in stocks again. That is until they hear how much money everyone else is making in the rebound. People have short memories. A few years after selling, the market is back to its all-time highs and the economy is strong. You realize your mistake in selling and get back in a higher price than where you sold. Not exactly following the “Buy Low, Sell High” investing motto.
Conclusion – Timing the Market is Difficult
Active investing is hard, if not impossible to beat the market for most. Trying to time the market, pick the next winning stock, and outsmarting everyone else may work from time to time, but is not a long-term winning strategy for the majority of people. But passive investing is easy, you just do nothing. The hard part is making sure that you follow the plan of letting your money work for you.
Watching your portfolio go down in value in a market downturn is troubling. But with reasons on why you should not sell and with some ways to cope, I hope I have made it a bit easier. My hard to access account will act as an additional reminder of not to sell, as well as a shield from the negative emotions of seeing your portfolio decline in value. Plus, with automatic investing you will automatically be buying the dips. Please leave comments on how you cope with market sell offs for us all to learn from.