Why Sitting Out Of Risky Markets Is A Bigger Risk Than You May Realize

Why Sitting Out Of Risky Markets Is A Bigger Risk Than You May Realize

Behavioural psychologists often talk about “loss aversion” or “negativity bias”. Both phrases essentially mean that people experience loss more intensely than gains. In other words, for every dollar you lose, you need to get back two to offset the emotional pain. Everyone talks about the fear of missing out, but the fear of losing is just as real.

Can you see the future?

Here’s the problem: no one knows what the market will do. Even the most experienced analyst or economist can only predict whether it will go up or down within a certain period based on the conditions they see at the time. Despite what some TV talking heads tell you, no one has a crystal ball. For example, did anyone really see the pandemic coming?

When you move money based on what you think will happen, you’re trying to “time the market”, something nobody in the history of investing has done successfully with any real consistency. And when you choose to exit the market, in effect you’re making two timing calls – predicting the market high (when you get out) and the market low (when you get back in). It’s a fool’s errand.
What if you tried to do the next best thing and rather than predict the stock market, you just react quickly? It’s not that simple. Stocks have a nasty habit of whipsawing even the most experienced investor – a declining market can bounce-up before significantly dropping once again. And, when the real recovery does happen, it often happens in a couple of very sudden and rapid movements. Whether you are trying to catch a falling knife or jump on a train moving at full speed…the likelihood of success is not in your favour and there is a great deal of risk involved.

Counting that cost of sitting out

When you get the timing even slightly wrong, you can miss out on the market’s best-performing days. And there’s a lot of research to show just how costly that is.

In a 2018 report, Morningstar did an analysis to see how much an investor could have earned in returns by staying invested in the U.S. stock market from 1997 until 2017, which included 5,217 trading days. That number, it turned out, was 7.2%. But if that investor had missed just 10 of the best days in the market during those 5000+ trading days, they would have only earned 3.5%…less than half of the investor that stayed put. Miss 20 days, and their return shrank to 1.2%.

There is no better recent example than 2020 – A February 2021 analysis from Brompton Funds, a Canadian investment fund firm, found that someone who stayed invested in the S&P 500 through the course of 2020 – including the bear market caused by the pandemic – would have been rewarded with an 18.4% return for the year. Missing just the market’s single best day would have cost them more than 10 percentage points, bringing that return down to 8.4% or less. Not being invested on the two best days of the year would have turned their 2020 into an annual loss of -1%.

Here’s the kicker: the best-return days in 2020 happened in March, the same month when market fear was at its highest and many investors had already run for the hills. Remembering that at this point in time there was still complete uncertainty around the future course of the then, early-stage pandemic. Not to mention Trump was in office and playing the trade-war game with China. With all the risk and uncertainty swirling around the markets, how many investors out there felt confident that we had seen a market bottom? How many were so confident that they actually had a strong enough conviction to put money on the sidelines back to work?

How to stay invested

The question should not be whether you are invested but how you are invested, which depends on an individual’s stage of life and risk tolerance.

For example, let’s say you’re a young investor in your early to mid-twenties. You’ve got a job that pays a decent income, and you’re just hitting your stride in your professional and personal life. You’ve got decades before you retire, and are working on goals like travelling, getting married, getting your kids through school, owning a home, building a nest egg, and maybe even leaving a legacy.

For you, wealth accumulation is top priority, and time is on your side. Historically, the stock market has been up far more times than it has been down. You also still have a lot of earning potential and ability to recover from any dips in the market. You can afford to be bold and invest a bigger chunk of your portfolio in equities.

However, if you’re retired and, in your sixties, or seventies, you may be more focused on preserving what you have as you don’t have the parachute of time or a working salary. Having said this, if you have the self-awareness to know how long you can tolerate turning a blind eye to markets, the market will usually resolve itself. Therefore, if knowing that holding onto 6 months worth of expenses will enable you to avoid reacting to market turbulence, this may be all the cash you need in your portfolio. If you are closer to retirement, maybe that amount of cash increases to 1 or 2 years worth of expenses. This type of game-plan will mean you don’t need to exit the market at the first sign of trouble. Nor remain uninvested, on the sidelines, until just the right time comes along, while your valuable investment years tick away.

For you, a portfolio that is designed with a defensive approach and asset allocation, may be a more appropriate fit. Of course, the specific strategy will depend on the individual’s circumstances. If you are not comfortable managing your portfolio in challenging markets, this is where an independent investment advisor will be able to assess the situation and help you navigate the storm.

Remember, time in the market beats timing the market, every time.

ETF Capital Management

At ETF Capital Management, our mission is to enhance your peace of mind by reducing investment volatility, to help you stay the course in order to achieve your personal long-term return targets. Our vision is to help you achieve the highest possible standard of living, enabling you to realize your best and most fulfilled life.

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