Yes, the signs of stress are spreading across the global financial system at an alarming rate. No, this does not mean it’s a good time to bail on your investments.
In moments of heightened financial peril, it’s a reliable reflex for retail investors to want to reduce their exposure to risky assets. After all, if you can see the storm approaching, why not get out of town?
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Unfortunately, this can be one of the worst mistakes an investor can make. Selling into a falling market locks in losses that, up to that point, exist only on paper. And it sets up the hopeless task of trying to time the market rally once conditions improve.
Many investors simply never return to the stock market once they succumb to panic selling.
“Reducing market exposure through ill-conceived selling – and thus failing to participate fully in the markets’ positive long-term trend – is a cardinal sin in investing,” Howard Marks, the billionaire co-founder of credit fund Oaktree Capital Management, wrote in a recent instalment of his widely followed newsletter.
Personal finance site Finder recently polled Canadians on how they are navigating the bear market. It found that nearly one-quarter of Canadian investors had “no confidence” in the stock market and planned to “cash out” by the end of year.
It’s not hard to see where that sentiment comes from. This year so far has been one of worst stretches investors have had to endure.
Central bankers around the world have put an abrupt end of a decade-plus of easy money, with an orchestration of enormous interest rate hikes that have transformed financial markets.
Measures of strain in U.S. credit markets are approaching critical levels. The U.S. dollar has soared to the detriment of foreign currencies and economies. The yield on 10-year benchmark government bonds in Britain, which started the year below 1 per cent, has recently spiked to as high as 4.5 per cent, prompting the Bank of England to intervene. And Credit Suisse, one of the largest banks in Europe, appears to be fighting for its survival.
“Does it feel like something’s about to break? I would put a very serious probability on that,” said Stephen Lingard, the head of investment research of CI Investments’ multiasset team. “This transition from max monetary stimulus makes for a very dangerous environment.”
On Friday, after a brief pause, the stock market freak-out resumed when U.S. jobs data proved stronger than expected. Year to date, the S&P 500 index has lost 24 per cent, the tech-heavy Nasdaq Composite Index is down by 32 per cent and the S&P/TSX Composite Index is off by 12 per cent.
The combined selloff in both stocks and bonds means that this is one of the worst years on record for the classic 60/40 portfolio upon which many retirement plans are built. These are the times when retail investors start to get rattled by the enormous personal losses they see in their investment accounts.
But assuming their overall investment plan is sound and diversified, and their level of risk is appropriate for their circumstances, staying invested is almost always the right play. The vast majority of actively managed portfolios – even those run by professionals – fail to outperform the market.
Each year, Morningstar issues a report that essentially quantifies how much investors lose by trying to time the market. Over the 10-year period up to the end of 2021, for example, U.S. investors earned an average of 9.3 per cent annually on mutual funds and ETFs.
That’s 1.7 percentage points less than what their investments generated over the same period.
“This shortfall, or gap, stems from poorly timed purchases and sales of fund shares, which cost investors nearly one-sixth the return they would have earned if they had simply bought and held,” the report said.
For investors who panic sell and liquidate their equity holdings, the consequences can last a lifetime.
A group of MIT researchers recently analyzed panic selling across hundreds of thousands of individual U.S. brokerage accounts. They found that more than 30 per cent of investors who exit the stock market will never buy equities again, according to their study published in The Journal of Financial Data Science.
Those who do return to the stock market, unless they time the bottom perfectly, will miss out on the early days of a new bull market.
“After some calamity happens and we eventually hit bottom, immediately after that you tend to see massive up days,” said Izet Elmazi, chief investment officer at Bristol Gate Capital Partners. “If you miss those, you miss a lot of the game.”
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