An old rule of thumb when it comes to investing is that markets drop more quickly than they rise. Panic strikes suddenly, but optimism creeps in over time. That leads to situations like the most recent Wall Street slump that was preceded by headlines of retail investors diving into the market just before the crash. Fear of missing out on market returns finally won out over loss aversion 10 years into a near record-length market expansion.
There has been a good deal of research in recent years into how we think and how our approach can make us poor investors. The asymmetric nature of panic and optimism is just one example of why we aren’t wired for investing, but it is likely among the most harmful in terms of returns. So when markets turn tumultuous as they did in the recent Wall Street slump, I run through a list of questions to ensure I’m comfortable with how we’re invested. Here is what the list includes:
- What’s happening in the real world – what does the economic data tell us about the health of the economy, and what is the trend in corporate profits. Particularly in the U.S., there is a wealth of economic data available 1. Beyond economic data, the trend in corporate profits is also a helpful metric. Historically, bear markets don’t begin in a period in which (a) recession doesn’t appear likely within the next year or so, and (b) corporate profits are still rising.
- What are valuations – valuation measures, or how much you pay for a portion of a company’s assets or income, are poor timing indicators but they are good indicators of expected returns over the medium term. Put another way, they aren’t good at telling you when to invest, but they are useful in telling you where to invest. This is because valuations are mean reverting – if they are above average, expect a below average run for a time and vice versa for below average valuations. Lastly, while they aren’t good timing indicators, recognize that the higher the valuation (particularly when they are as high as they have been in the U.S.), the higher the risk.
- Can you stick with the portfolio through a downturn – if you’ve analyzed your portfolio, you should have a good idea of what a likely worst case scenario is, and you need to make sure that both you and your plan can tolerate that loss in a Wall Street slump. Furthermore, you don’t want to be in the position of being forced to sell assets that have dropped sharply in value, so make sure you have enough cash and conservative bonds on hand to cover cash needs through the market downturn. Lastly, it should go without saying, but you can’t time a downturn – so build a plan and determine your overall allocation before markets head south.
- Are the portfolio and the individual investments performing as expected – this is the most difficult question to answer, both because of the tools needed and because of the subjective judgement it requires. In terms of tools, you need to be able to track return versus a composite benchmark to confirm that return is in line with what you should expect. Further, aside from tools, you need to have the judgement to confirm the individual investments are performing as they should. Sometimes this is straightforward – if a conservative bond fund drops sharply in value while Treasuries are up in value, you should examine the fund with a health dose of skepticism. On the other hand, if you have a large cap value fund that invests in a handful of companies, divergence from the benchmark is, at some point, a given. If that same fund has outperformed during rising markets, don’t be surprised to see some underperformance in a down market but do make sure that, understanding that, it belongs in your portfolio.
Avoiding the temptation to sell when markets drop sharply is tough, and it is likely even tougher now given the blaring headlines and the 24/7 news cycle covering the recent Wall Street slump. Planning ahead of time and following the checklist when markets drop can help you make well-informed, rational decisions while many investors give in to panic.