Preparing for Future Market Volatility For the Long Term Investor
March 29, 2020
This post is targeted towards people in the wealth accumulation phase of their lives. It was specifically written with my peers and coworkers in mind who, on average, have greater than a 30 year investing horizon and are located in the United States. Since most of them are invested in target date retirement funds, it also assumes they are invested with an allocation between stock and bonds which fits their risk tolerance.
Current Events
As of March 27th, 2020, the United States stock market (VTSAX) is down about 26.3% from it’s all time high. Earlier in the week, the market was down about 35.0% [1].
After the 11 year bull run, the US stock market is officially in bear market territory which means it is more than 20% down from its record high. It seems likely that the measures taken to combat COVID-19 will lead to a recession since consumers are not out spending money and we are seeing an increase of over 3 million unemployment claims in one week [2]. Due to the expected decrease in earnings, many stock prices are plummeting as investors adjust their expectations in response to the news.
On Wednesday and Thursday of last week, the market seemed to bounce back up possibly in response to the passing of the $2 trillion coronavirus response bill through the Senate [3]. Although experts believe this will be a short, albeit deep recession [4], no one can predict with accuracy which way the market will go in the short term. This bounce could be the start of the next bull market or just a dead cat bounce.
“even a dead cat will bounce if it falls far enough and fast enough” - Investopedia [5]
What to Do?
If you are already investing for the long term in low-cost, broad-based index funds (such as a Vanguard Target Date Retirement Fund), the best course of action is to stay the course.
What does it mean to stay the course?
Continue Automated Investments
If you already have automated investments set up, don’t stress about whether or not to sell now to cut your losses. No one can predict which way the market is going in the short run.
If you have automated investments set up in your retirement accounts, you don’t even have to look at your accounts at this time especially if seeing how much money you’ve “lost” will cause you to stress out. You’re already all set. Just ignore the news about the stock market and carry on.
Continue Non-automated Investments
What if you don’t have automated investments set up? For example, I contribute to my Roth IRA once a year after I file my taxes. My advice would be to ignore the noise and go ahead and invest on the same schedule as you normally would.
In times of increased volatility, it may be tempting to wait and see if the market will drop some more before investing. However, I strongly advise against waiting to try to see if the market goes down because in the long run (30+ year time horizon) the US stock market has always gone up and so you are placing a bet with negative expected value.
Do Not Sell
The worst thing you can do is sell in a panic. There have been so many war stories of people who have sold in a panic during a market crash and then regretted it since it is impossible to predict when and how fast the market will climb back up. The money you have in the market should be invested for long term goals and in low cost broad-based index funds. Since these are long term goals, you do not need this money in the short term.
Exception: You can sell to regularly rebalance if that is part of your strategy. For example, if your strategy is to hold 60% stocks and 40% bonds and to rebalance annually, you might need to sell some bonds to buy more stocks to get back to your 60/40% allocation.
Risk Tolerance
As mentioned at the beginning of this post, this advice in given based on the assumption that you are investing for the long term. This means that you have 60-100% of your retirement portfolio in stocks as opposed to fixed-income assets such as bonds.
The advice to stay the course can also be applied to those with shorter time horizons as long as their allocation between risky assets such as stocks and fixed-income assets match their risk tolerance.
Your Portfolio’s Worst Enemy
Look in the mirror.
“The Dow started the last century at 66 and ended at 11,400. How could you lose money during a period like that? A lot of people did because they tried to dance in and out.” - Warren Buffett [6]
Your worst enemy and “the person most liable to screw up your retirement portfolio is you” [7].
In a 2013 article on The Wall Street Journal, Jonathan Cheng documented one couple’s reaction to the stock market [8]:
When stock prices collapsed in 2008, the bear market wiped out half of the savings of Lucie White and her husband, both doctors in Houston. Feeling “sucker punched,” they swore off stocks and put their remaining money in a bank. This week, as the Dow Jones Industrial Average and Standard & Poor’s 500-stock index pushed to record highs, Ms. White and her husband hired a financial adviser and took the plunge back in to the market.
Even the best investment plan couldn’t save these investor from themselves as fear caused them to panic and sell and lock in their losses. After the market had recovered far beyond the previous highs, the fear of missing out finally drove them to reinvest in the market.
Although we can see what mistakes others have made, we cannot know which mistakes we will make in the face of panic until we have rode out those situations.
During the 2008 global financial crisis, when the Dow Jones was down over 50% from its high, “experts” were comparing the fall to the Great Depression:
Market strategist Phil Dow believes distinctions exist “between the current market malaise” and the Great Depression. He says the Dow Jones average’s fall of more than 50% over a period of 17 months is similar to a 54.7% fall in the Great Depression, followed by a total drop of 89% over the following 16 months. “It’s very troubling if you have a mirror image,” said Dow. [9]
Thinking about losing 90 percent of your savings is not nearly as unimaginably upsetting as actually losing it - as many people did during the Great Depression. In fact, some people who borrowed money to invest lost even more than 90 percent. Furthermore, during these crashes, no one had the ability to see just how much and how fast or slow the market would recover.
There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own. - Fred Schwed [7]
Although the market has only fallen 30% so far during the COVID-19 pandemic, in the short term, things could suddenly look a lot worse or a lot better. We just have to remember to take a long term perspective and remind ourselves that we are investing for the long term.
Practical Steps
So with the additional perspective we can derive from the current pandemic, let’s figure out what we can do in preparation for the upcoming economic crisis.
1. Build Your Emergency Fund
Before you can invest, you need to have an emergency fund.
The current bear market is a good reminder that we cannot predict what the market will do in the short term so any money we need for short term goals should not be invested in risky assets like the stock market.
A common rule of thumb is keeping 3 months to one year’s worth of expenses to deal with emergencies such as a loss of a job. Refer to the Bogleheads Wiki “Emergency Fund” page for suggestions on where to park these funds [10].
Resist the temptation to invest these funds in risky assets such as stocks or illiquid assets. Your emergency fund is to protect you from withdrawing from your long-term investment funds early so that you are not forced to withdraw money at the worse times when your portfolio is down.
For example, during the Great Depression, unemployment was high and the market was down around 90%. Unemployed people who were not able to live off their emergency funds were withdrawing money from their portfolios at the worst possible time. Not only were they withdrawing money at pennies on the dollar, but also they were sabotaging their portfolio’s chances to recover and compound (assuming they had the mental fortitude to stay invested).
2. Write an Investment Policy Statement (and Choose Your Risk Tolerance)
Although reading and studying historical bubbles and subsequent crashes has helped mentally prepare me for a recession, I had never previously watched my portfolio go through a recession. In order to prepare for the worst, I wrote an Investment Policy Statement (IPS) which would guide my investment decisions through the short term swings of the market such as the current pandemic-based recession.
An Investment Policy Statement is a statement that defines general investment goals and objectives. It describes the strategies that will be used to meet these objectives and contains specific information on subjects such as asset allocation, risk tolerance, and liquidity requirements. - Bogleheads Wiki [11]
It does not have to be complicated. Even a simple investing plan will help as long as you stick to the plan through the roller coaster ride that is Mr. Market.
As you flesh out your plan, you will have to determine your risk tolerance to see how much of your portfolio will go to stocks versus bonds. You may also have to reflect on how your perspective on the global markets will affect how you invest in US stocks versus international stocks. Although these topics are beyond the scope of this article, using the allocations in the Vanguard’s Target Date Retirement Funds for your target retirement date is a good place to start [12].
Here is a simple example based again on fellow Boglehead Sunny’s IPS which you can use as a starting point:
Investment Philosophy: "Buy-and-hold, long-term, all-market-
index strategies, implemented at rock-bottom cost, are the
surest of all routes to the accumulation of wealth."
- John C. Bogle
Asset Allocation: Maintain overall 60% stock + 40% bond
allocation in retirement accounts. Maintain overall 60%
US market and 40% international market allocation in stocks
and bonds. Keep $X dollars for a six month emergency fund.
Funds & Accounts: Use low cost mutual funds - index funds
preferably - which do not overlap and provide maximum
diversification across asset classes. Try to assume only market
risk as far as possible. Try to shelter tax-inefficient funds in
tax-advantaged accounts to reduce tax drag.
Retirement Funds Target Allocation:
Vanguard LifeStrategy Moderate Growth Fund (VSMGX) - 100%
Emergency Fund
$X in savings account
Other Considerations: Automate future contributions wherever
possible. Rebalance yearly. No market timing. Exact sub-
allocations are not as important as maintaining the overall
60/40 stock/fixed allocation - no need to make things complex in
order to meet sub-allocation targets. Use this example or another example from the Bogleheads Wiki page to get started. It will help to spell out why you believe in your plan as well so that in the face of the next crash, you can stick to your plan. I have included my original Investment Policy Statement at the end of this article as well.
Don’t overthink your initial strategy. Just keep it simple and put it in writing so you can reference it later on.
3. Automate
Assuming you have thought through and have chosen an allocation which is appropriate to your risk tolerance, your Investment Policy Statement should be ready to get you and your portfolio through any future crashes. However, none of us have a crystal ball nor balls of steel. So it is best to avoid relying solely on discipline.
No plan survives contact with the enemy. - Helmuth von Moltke the Elder
To avoid second guessing your investment strategy in the face of crisis, try to automate as much as possible.
Set up automated payroll deductions. This will allow you to take advantage of dollar cost averaging - buying more stock when the market goes on sale during the bear markets. In addition, you will be spared the temptation of spending your money before saving for retirement. And if you know you are prone to panicking, you won’t even have to look at your retirement portfolio during the upcoming recessions.
Final Thoughts
Hopefully we and our loved ones all survive this pandemic. It is a reminder that in the grand scheme of life and death, money does not mean that much.
If you are fortunate enough to have a stock portfolio, stay the course and take the steps to ensure that you can stay the course in worse market crashes.
If you do not have an emergency fund, please save up for that fund first!
If you do not already have an Investment Policy Statement, please write one as soon as possible and automate as much as possible so that you can stress out over more important things like you and your family’s health and safety!
Addendum
In case you need another example, here is the plan that I had emailed to myself when I first learned about having an Investment Policy Statement in college based on fellow Boglehead Sunny’s IPS:
WEALTH ACCUMULATION STAGE
Investment Philosophy: "Buy-and-hold, long-term, all-market-
index strategies, implemented at rock-bottom cost, are the
surest of all routes to the accumulation of wealth."
- John C. Bogle
Asset Allocation: Maintain overall 100% stock allocation until
financial independence to accommodate long-term requirements.
Assets should be diversified across major asset classes
including domestic equity and international equity (25-35% of
equities).
Funds & Accounts: Use low cost mutual funds - index funds
preferably - which do not overlap and provide maximum
diversification across asset classes. Try to assume only market
risk as far as possible. Try to shelter tax-inefficient funds in
tax-advantaged accounts to reduce tax drag.
Target Allocation:
VTSAX - 70% - Roth IRA, 401k, Taxable Account
VTIAX - 30% - Taxable Account
Other Considerations: It is better to have VTIAX in a taxable
account because of the foreign tax credit. Rebalance yearly if
investments are automated, otherwise rebalance per paycheck (to
avoid selling shares).
WEALTH PRESERVATION STAGE
Asset Allocation: Maintain overall 75% stock, 25% bond
allocation after financial independence in case of emergencies
or retirement. Assets should be diversified across major asset
classes including domestic equity and international equity
(~33% of equities). Assets can be withdrawn at 4% of portfolio
per year after retirement (see Trinity Study). Reduce
withdrawal if 4% and economic downturn in first few years of
retirement.
Target Allocation:
VTSAX - 50% - Roth IRA, IRA, 401k, Taxable Account
VTIAX - 25% - Taxable Account
VBTLX - 25% - IRA
Other Considerations: Allocation should be simple so that spouse
can easily manage it in case of death. Greater stock allocation
than suggested by jlcollinsnh(50/50) in case of early retirement
or ability to take on more risk because expenses < 4%. Keep
VBTLX in tax protected account since it is the most tax
inefficient.My investing philosophy was heavily influenced by Mr. JL Collins who wrote perhaps the best, most simple, and most influencial series on investing in his Stock Series.
Over the years, I have added other short and medium term objectives such as saving for vacations or big expenses. I have also edited my IPS to reflect new accounts such as my 401(k) once I started working. However, the core principles (low cost index funds and target allocation) have not changed.
The most important thing is that with this plan, I knew that my strategy was going to be the same in a bear or bull market.
References
[1] VTSAX closed at a high of 83.79 in February 2020 and reached a low of 54.49 this week (March 2020). Currently it is at 61.76. Source: Marketwatch
[2] “In the week ending March 21, the advance figure for seasonally adjusted initial claims was 3,283,000, an increase of 3,001,000 from the previous week’s revised level.” Department of Labor News Release
[3] What’s Inside the Senate’s $2 Trillion Coronavirus Aid Package
[4] “which would mean the recession although it will be very deep, ironically could also be the shortest in our history” - Joe Davis, Vanguard Global Chief Economist Perspectives on a U.S. recession
[5] Dead Cat Bounce Definition
[6] [Stocks — Part III: Most people lose money in the market.] (https://jlcollinsnh.com/2012/04/25/stocks-part-iii-most-people-lose-money-in-the-market/)
[7] If You Can - William Bernstein
[8] Mom and Pop Run With the Bulls - The Wall Street Journal
[9] Financial crisis of 2007-08 - Wikipedia
[10] Emergency fund - Bogleheads Wiki