Warren Buffett says, “Be greedy when others are fearful and fearful when others are greedy.” It’s tough to embrace Buffett’s mantra when your hard-earned money seems like it’s swirling around in a toilet. But if you’re at least five years from retiring, you should prefer to see stocks fall.
After all, when purchasing market assets, we’re much like collectors. We should prefer falling prices for things we’re collecting. Eventually (it might take a year, it might take five) those prices will soar. The more we can collect, when socks are low, the more money we will make.
Twice before, I collected in hyper-drive: during the market crashes of 2000-2002, and again in 2008-2009. But I tightened my fiscal belt. I spent less money on holidays and restaurants so I could invest more. I also grabbed extra writing gigs to increase my income, so I could scoop up bargains when stocks were on sale. Young investors, especially, should celebrate market drops.
Retirees, however, cheer for a different team. They should hope to see stocks rise. Yet if they stick to a solid plan, they shouldn’t run out of money.
This brings us back to Warren Buffett’s quote: “Be greedy when others are fearful...” Diversified portfolios of stocks and bonds can help you do that. Buffett keeps a war chest of cash that he deploys when stocks drop. Similarly, you could use bonds.
Assume you own a diversified portfolio of low-cost index funds or ETFs. When stocks drop hard, bonds offer dry powder. They also act as parachutes. For example, measuring the year-to-date returns of the S&P 500 to March 26th 2020, the index dropped 18.24 percent. In that case, a $100,000 investment would have plunged to $81,760.
But if the portfolio included 60 percent U.S. stocks and 40 percent U.S. bonds, the same $100,000 would have fallen to $89,960. That’s a drop of just 11.04 percent.
How Bonds Help To Cushion Market Drops
January 2020 – March 26, 2020
|Vanguard’s S&P 500 (VFINX)||-18.24%|
|Vanguard’s Bond Market Index (VBMFX)||+2.12%|
|Balanced Portfolio Return (60% stocks, 40% bonds)||-11.04%|
Such a drop would have been much easier on the nerves. What’s more, the bonds offer opportunities to buy cheap stocks. If the investor’s allocation of stocks/bonds drifts 10 percent or further from their goal allocation, investors could rebalance. That would require selling some of their bond market index and adding the proceeds to their stock market index. In other words, being greedy when others are fearful.
By maintaining your original goal allocation, you would be selling some of your winners (in this case, bonds) and adding the proceeds to your losers (in this case, stocks).
Unfortunately, most people cringe at that. It might feel much like ripping off a nail. When stocks go haywire, far too often, people try to protect themselves, sometimes selling stocks, or ceasing to add fresh money. No matter how you slice it, that’s a futile attempt to time the stock market. And that costs investors plenty during volatile times.
For example, during the ten-year period ending December 31, 2013, stocks jumped around a lot. They fell hard from 2000-2002. They plunged once again in 2008. But over that decade, U.S. stock market funds averaged 7.3 percent per year, after fees. That isn’t bad at all.
But according to Morningstar’s Mind The Gap Analysis, the typical investor in U.S. funds pooped the bed. They averaged just 4.81 percent over the same ten years. If people were rational, that wouldn’t have happened. If America’s mutual funds averaged 7.3 percent after fees, investors in those funds should have earned the same returns. But they didn’t. The average investor was fearful when others were fearful and greedy when others were greedy. As a result, they enjoyed paying higher prices for their stock market assets after stocks had risen and they shunned stocks after they went on sale.
Unfortunately, that always happens when stocks jump around. It’s why Buffett’s mentor, Benjamin Graham said, “You pay a high price in the stock market for a rosey consensus.”
Instinctively, it’s tough to rebalance after stocks have dropped. But if you own a Target Retirement fund or invest with a disciplined investment firm, you won’t have to. The product or the firm will rebalance the holdings for you. Arm’s length investing often works best. And not thinking about the markets might be best of all.
One of the funniest examples comes from Business Insider’s Myles Udland’s interview with James O'Shaughnessy, who was the head of a U.S. investment firm. O’Shaughnessy had recently hired a former employee at Fidelity, one of the world’s biggest mutual fund companies. The employee said the mutual fund giant conducted a study to determine its best investors. Were they young investors? Were they old? Were they followers of investment news? Instead, the firm’s best investors were people who forgot they had an account with Fidelity.
Recent market volatility is testing you now. The biggest question isn’t about the national debt, or the Coronavirus, or how much toilet paper the White House might be stocking up. This test is about you, and how you can handle scary stories and hard-falling markets. If you’re employed, keep adding money. Maintain a consistent allocation between stocks and bonds. Rebalance when needed. If you’re retired, prepare to stay the course. This just might be your chance to channel your inner Buffett.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas