“”Sure it would be great to get out of the stock market at the high and back in at the low, but in 55 years in the business, I not only have never met anybody that knew how to do it, I’ve never met anybody who had met anybody that knew how to do it”
- John Bogle, founder of Vanguard
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves…”
- Peter Lynch, Fame Investor at Fidelity Investments
One fact that should not come up as a surprise is the coming of a market correction. Many economic pundits have been calling for this much anticipated correction (but disappointed in the last 4 years), and they will be proven…CORRECT. What would impress me more, is if they can consistently time the coming of these market corrections; can you imagine the vast fortunes that can be made with perfect predictions? (WOW!)
Unfortunately, I have not seen any peer reviewed, credible resources that highlight the holy grail of algorithms, perfectly predicting the boom and busts of the stock market. It is one that I put into the bucket of “uncontrollables” in life, and I would rather spend my time and effort on the “controllables.”
I think the biggest of fear of market corrections is that I WILL LOSE MONEY!!! Let’s make sure we understand key facts that have happened since 1920s before you come to that conclusion.
- Corrections are defined as a drop of 10% or more, and we normally see market corrections happen every year! If you are retired now at age 65, you can potentially see more than 20 market corrections during your lifetime
- Corrections lead to Bear Markets. Bear markets are declines of more than 20%, and investors like to sell “early” during corrections to avoid the “paws” of the bear. Key wisdom is to know that most market corrections do not become Bear markets. In fact, only 20% of market corrections officially go into bear market territory.
- Out of the 100+ market corrections since 1920, how many time has it recovered? You are right when you say 100%…
Knowing this, how dangerous would it be to sell and go to cash, only for the market to “rubber band” back up to positive territory? Would your financial independence plan survive these potential mistakes in market timing?
Market Timing as Misplaced Risk
Let’s say that our investing timing is the absolute worst…we invested, and the markets come crashing down 45% (think 2008-2009). When we own broad based indices (not stock or sector funds), we continue to collect dividends and interest, all the while waiting for the market to move up (which it eventually will- see statistic above). So we got paid interest, dividends, and better returns due to opportunistic rebalancing as we buy more at lows.
If we were out of the market in 2008-2010 because of market timing, then we lost over 183% return of the S&P 500 through 2014. That investor will never be able to get back those returns. They are STUCK! This is where the real risk lies when it comes to timing highs and lows – see Peter Lynch quote above…
Markets can be volatile, we sort of forgot that the last 5 years when investing was “easy”. It is important to have a strategy in any market environment, even more so during market pullbacks. We have seen this before and we take advantage by doing opportunistic rebalancing and tax loss harvesting when appropriate.
This tactic allows you to systematically dollar cost average during market lows. Rebalancing for us is not a function of time, rather, a function of the market environment. We need to act on moments when we can sell bonds (tend to maintain its value during corrections) to buy more stock at lows. We don’t know if this will be at the end of the year, fiscal or calendar, or quarter…rather, we are ready when the market gives us openings. When we have the eventual recovery, these are the moves that will allow you to outperform.
This tactic has been documented with the Journal of Financial Planning. They have found incremental increase in returns when opportunistic rebalancing is made during market corrections.
Tax Loss Harvesting
A benefit of investing in broad indices during market pullback, is that it allows us to harvest losses. We never invest with the intent of losing money; rather, due to the nature of different asset classes (see Callan chart), investments move up and down during different times. We take advantage of these non-correlated movements of assets by selling positions at a loss and reinvest in a position that is different but highly correlated. This is something important to do so you can accomplish the following:
- Avoid the IRS Wash Sale Rule, which disallows the loss if invested in “substantially same security”
- Keep trade performance neutral. If markets quickly recover, your money is not in cash, but will move up with the performance of the market
This tactic is also documented. Here is the “pocket value” or money in your pocket by utilizing this strategy:
So as we usher in a period of volatility, let’s have the wisdom to understand what we can control and what we cannot control. We will see market correction…GUARANTEED. Rather than fear this pullback, with a proper strategy, it gives us opportunities to get ahead.
Rollan E Dizon