How Rational Investors Are Responding to the Coronavirus
Updated: Apr 25, 2020
It has been a scary month. To say nothing of the actual scary aspect and health implications of the Coronavirus. It has also been a scary month for investors. At the time I write this, The S&P 500 index is down nearly 35% from its previous high on February 19th. Since that time we have seen multiple days with double digit percent losses.
Those are some scary numbers that we have not seen since the financial crisis in 2008-2009. For younger investors (like myself) we have never experienced this kind of turbulence in the stock market.
Historically speaking, the past 11 years of investing has been a relatively smooth ride to the top. In what feels like a blink of an eye the investing landscape has changed as stock prices have quickly tumbled.
The question on most investors' minds is "What should I do now?"
I won't tell you what you should do, but I'll tell you what I am doing and what rational investors are doing in response to the Coronavirus; Absolutely nothing.
In this article, I'm going to review why the rational response to extreme market volatility is to continue your current investing strategy.
The one caveat I will add is that I am speaking from the perspective of the rational long-term investor. If you are in retirement or near retirement, you may want to review your investment strategy with an advisor to ensure it still meets your needs.
Paper losses and real losses
There are two groups of investors that got hammered and never recovered their losses during the financial crisis.
Those who made a fear-based decision to sell at the bottom of the market.
Anyone who had recently retired during the financial crisis simply ran into bad luck. The stock market declines by 40% during a time where they were forced to live off their portfolios. Not only did they suffer a decline in value, but they were withdrawing from their portfolio to cover their living expenses.
For a well-diversified investor this is the greatest risk of all, bad luck. The bad luck of the market tanking at the worst possible time.
If you were young in 2008-2009 and kept investing more money every year over the past 11 years, your portfolio is almost certainly firmly "in the black" even after recent market declines.
The second group of people who had their portfolios wiped out during the financial crisis were investors who got scared and sold their investments near the bottom of the market. In doing so, they turned temporary or "paper losses" and locked them into "real losses".
Paper losses can impact your sleep, real losses can impact your retirement.
If there is a lesson that we can learn from the financial crisis and apply it to the Coronavirus situation, it's to avoid making a fear-based decision to sell when the market tanks. If you're going to sell any positions, it should be part of a well thought out plan not in reaction to some scary headlines.
If you want to reduce the fear and anxiety at a time like this, I would start by turning off the news and stop checking the balance of your portfolio every day.
The irrational investor is selling right now while the rational investor is staying the course with their long term strategy.
This is why we invest in bonds
For years I have been writing about why DIY investors should be allocating some of their portfolio to bonds. I have gotten a lot of pushback on that point because bonds have a lower expected return than stocks. Since the stock market has been doing nothing but going up for the past decade, many investors got complacent and believed that would continue forever.
The kind of market volatility we have experienced over the past month is the entire reason investors allocate a part of their portfolio to bonds. Typically when the stock market is experiencing steep losses, investors flock to safer assets like bonds. This increases the demand for bonds and pushes their price up.
Having a portion of your portfolio that increases in value while the stock market is tanking makes the ride a little less bumpy. Smoothing out the ride is the entire point of investing in bonds.
Vanguard has compiled some interesting data on the expected returns and volatility of portfolios that range from 100% bonds to 100% stocks. The following data is from 1926–2018.
The single worst year for a portfolio invested in 100% stocks was a 43.1% loss in 1931.
The single worst year for a portfolio invested in 60% stocks and 40% bonds was a 26% loss, which also occurred in 1931.
Bonds reduce the volatility in our portfolio. However, the true value of bonds is managing "behavioral risk". The risk that investors will freak out when the stock market drops by 43.1% and sell at the bottom and lock in devastating losses.
Bonds help prevent investors from making irrational decisions.
The value of a great financial advisor
I manage my own investments and believe that it has never been easier to be a DIY investor. You do not need to be a financial expert to build a strong portfolio. The "science" of investing has more or less been figured out.
Invest in a few low-cost index funds.
Diversify by asset class (stocks and bonds).
Diversify by geography (invest in multiple countries).
Don't sell at the bottom.
If you follow that formula, you have a high probability of success.
The last point is the most difficult for DIY investors. Especially those who are getting their first taste of real stock market volatility this month.
This is where the value of a great financial advisor comes into play. Since the science of "how to invest" is more or less solved, the true value of an advisor is their ability to coach and manage their client's behavior. Especially when stock prices are dropping fast.
The past month will tell you a lot about whether you are cut out to be a DIY investor. If you have had the strong impulse to sell and get out of the market, you may not have the stomach for DIY investing.
Which is completely fine by the way. It does not say anything about your character as a person. It simply means that your finances are likely better served if you hire a financial advisor who can help steer the ship through rough waters.
The recent volatility in the stock market has raddled a lot of investors. It’s important to remember not to make fear-based decisions and to embrace diversification.
Rational investors are evaluating their plans and staying the course.
If you feel like the stress of managing your portfolio during times like this is too great, you might consider hiring a professional who can help you through the storm.
If you're ready to master your money, don't forget to enroll in my video-based personal finance course, "Millionaire In The Making: The 30-Day blueprint" Click here to enroll.
This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.