Advice & Dissent

Jack Calhoun | Principal

Examining the common (non)sense that causes investors to fail.

Flight or Freeze?

August 2012

“Don’t just stand there – do something!”

That is the refrain of anxiety, fear and panic. It is the fight-or-flight survival instinct put into words – a plea to do anything other than stay put.

Sometimes the notion of taking action makes perfect sense. If, for instance, your car stalls out on the railroad tracks and a freight train comes barreling around the bend, then staying put is clearly unwise.

When it comes to investing, however, the notion of “taking action” during times of perceived danger in the market is misguided and dangerous. And it is precisely the sort of counter-intuitive concept central to investment success that very few people who manage their own portfolios are ever able to understand or embrace.

Before we explore this notion in more depth, a caveat: The wisdom of staying put during periods of market turmoil depends entirely on the soundness of your current strategy. Investors with portfolios heavily concentrated in individual stocks or invested in narrow market sectors should indeed take action to diversify their portfolios, but the time do this is before the market volatility swoops in and knocks your portfolio value in half or more. (See: Wachovia, Delta, GM, et al.)

For those who are invested in a well-diversified portfolio strategy, it is vital to stay the course in times of turmoil. Unfortunately, the “blink moments,” as we call them, always coincide with the exact moment of maximum stress in the market. The greater the stress, the harder it is to say put, because every time we pick up the paper, click on the financial web site or turn on the TV, we hear the “experts” urging us to “do something.”

But what, exactly, is the “something?" This is the logical next step in this progression and the one that people usually fail to consider. When panic sets in, as it did in the fall of 2008 and again in the summer of 2011, investors become obsessed with “fleeing from” without considering what they are “running to."

With that in mind, let’s examine what investors historically have considered the safe havens in times of turmoil to see if they really are a safer alternative to stocks:

Gold: Gold is often touted as a safe haven in turbulent markets and as a way to moderate volatility or even generate healthy returns. The reality, however, is that gold is a more volatile asset than common stocks. Over the past 10 years, the volatility of gold (as measured by standard deviation) was 19.06% versus S&P 500 volatility of 15.99% -- and this was during a decade that saw three significant market declines! Many people fled to gold following the downgrade of the U.S. debt rating in August 2011. And yet from September 2011 through June 2012, the price of gold plunged from $1,884 to $1,599, a decline of 15.13%. During the same time, the S&P 500 rose 16.01% from 1174 to 1362. Those who fled stocks for gold and thought they were getting “safety” actually suffered a cumulative loss of more than 30%!

Bonds: Fixed-income is the traditional asset class used to moderate equity volatility. In the past four years, however, individual investors have flooded into fixed income as a refuge from the perceived risk of investing in stocks. In just the second quarter of 2012 – and despite a 30% gain in stocks the prior six months – volatility-weary investors pulled $35 billion from stock funds and plowed $59 billion into bond funds.

Unfortunately, many such investors are only trading a perceived risk for a guaranteed risk. Having found the extremely low yields of high credit quality bonds to be unattractive (the current Barclays Aggregate Bond Index yield is 2.01%), many investors are running to high yield, low credit quality bonds in pursuit of returns. Unfortunately, these junk bonds will suffer significant losses of principal when interest rates rise, exposing their investors to significant volatility. As seen in the chart below, high yield bonds have risk more closely aligned with equities than high credit quality bonds.

On top of this, the low interest rate environment and high demand for safer assets has driven bonds to significant premiums when compared with equities. The Price to Earnings ratio of the Barclays Aggregate Bond Index has skyrocketed to 49.75 vs. 13.88 for the S&P 500.

Cash: There can be a temptation to throw one’s arms up, pull out of the market and seek the safety of cash amid uncertainty. However, there is a very real risk of loss of purchasing power if fleeing exclusively to cash. Inflation in the U.S. as measured by the Consumer Price Index has been 3.57% over the past 80 years. With current average money market rates at 0.48%, inflation will rapidly erode a pure cash position’s real value.

Often times investors view a move to cash as temporary, vowing to get back in the market once volatility subsides. Unfortunately, such investors usually make a move to cash after they have experienced the downturn and then fail to get back in the market in time for the subsequent rebound. Investors pulled billions from stock mutual funds last fall and fled to cash after the market’s dramatic plunge following the downgrade in the U.S. credit rating. Those who waited just two months to get back in the market, however, missed a 13.44% gain in the S&P 500, and if they waited six months they missed a 29.09% gain.

The bottom line is that investing involves risk. The best way to mitigate that risk is to have a well-diversified portfolio and a proper balance of stocks and bonds appropriate to your risk and return needs. After that, the best strategies you can employ are time, patience, faith and fortitude. History shows that market downturns have always worked themselves out over time – if you stayed put.

As one of the industry’s most respected and revered figures, Vanguard founder John Bogle, says about market downturns:

“Don’t just do something – stand there!”

Data sources: Morningstar Direct, finance.yahoo.com, www.kitco.com, www.standardandpoors.com, Dimensional Returns 2.0

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