From AAII Journal Update 4-2-20
Editor’s Note:
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As I write this in mid-March, the global financial markets are in turmoil because of COVID-19 (the coronavirus) pandemic and, secondarily, the oil dispute between Saudi Arabia and Russia. The pandemic has led to a massive drop in travel. In many localities, bars and restaurants have either closed, limited themselves to drive through or are spacing out customers. Here at AAII, my colleagues and I are working remotely.
The outbreak is being treated as a black swan; a highly unusual event. There have been many pandemics throughout history, though the worry about COVID-19 is the possibility of it turning out to be the worst since the 1918 Spanish flu. The coronavirus was not something most strategists were describing as a major threat. Yet, it has already led to the largest daily decline in the S&P 500 index since the October 1987 crash.
The steep drop in the equities, commodities and high yield (aka, junk bond) markets have been a gut-check for many seasoned investors. It certainly reminded those of us in this group about how much downside volatility we’re able to tolerate. It has also tested our ability to react in a real-world environment. It’s one thing to call yourself a contrarian; it’s another to open your wallet when others are pounding on the sell button.
For those who are investing in their first bear market, it’s a splash of cold water. No amount of reading or talking to others can prepare someone for the experience of knowing their investments are falling in value on a seemingly daily basis. As former boxer Mike Tyson once said, “Everyone has a plan until they’re punched in the mouth.”
Those of us who pay attention to behavioral science have long known that the risk assessment tests given by many advisers to their clients were problematic. Tolerances for being able to withstand a drop in portfolio value vary over time. A typical investor taking a risk questionnaire in October 2019 and again in March 2020 would give different answers about how much downside they are willing to tolerate.
How you feel and how you act, of course, are two different things. We’ve seen this pattern with our Sentiment Survey and our Asset Allocation Survey. The swings in the weekly sentiment readings are much larger than the fluctuations in allocations.
Our surveys show AAII members to be less reactive than the so-called “smart money.” Individual investors are not responsible for causing the large swings in asset prices. Rather, it has been the trading firms with their ultra-short-term focus that have caused the big price moves. These firms are ultimately managing money for pensions, endowments and other large-money investors.
Regardless of whether you’ve reacted to the coronavirus bear market or not, it’s worthwhile to take the time to write down your observations now. Think about how you felt (and currently feel) and what you’ve actually done. Did you sell out of fear? Did you buy? Did you buy and then sell after seeing the price of the investments you thought were cheap get even cheaper? Did you do a Roth IRA conversion? Did you harvest tax losses while being careful to avoid the wash sale rules?
Don’t judge yourself; just be observant and honest. Knowing how you react in the face of adversity will help you determine how much downside volatility you can withstand. It may also prompt you to consider changing how you engage with your portfolio and your investments. Once the bull market comes back and stocks rise to new highs (the timing of which is admittedly uncertain as I write this), you can contrast your feelings and actions then with what you’ve felt recently. Somewhere in the middle is a happy medium you can be in.
Not only is this a good exercise to do, but it is also timely: April is Financial Literacy Month. You’ll notice several articles tied to the subject in this issue. Contributing editor Chris Pedersen illustrates how a portfolio allocated to target-date funds can be improved here. Fellow contributing author Craig Israelsen offers mutual fund ideas here for those who are just starting to invest. And here, your fellow AAII members talk about what they’ve done to get children and grandchildren started in investing. Read them and share them.
Wishing you prosperity and good health,
The outbreak is being treated as a black swan; a highly unusual event. There have been many pandemics throughout history, though the worry about COVID-19 is the possibility of it turning out to be the worst since the 1918 Spanish flu. The coronavirus was not something most strategists were describing as a major threat. Yet, it has already led to the largest daily decline in the S&P 500 index since the October 1987 crash.
The steep drop in the equities, commodities and high yield (aka, junk bond) markets have been a gut-check for many seasoned investors. It certainly reminded those of us in this group about how much downside volatility we’re able to tolerate. It has also tested our ability to react in a real-world environment. It’s one thing to call yourself a contrarian; it’s another to open your wallet when others are pounding on the sell button.
For those who are investing in their first bear market, it’s a splash of cold water. No amount of reading or talking to others can prepare someone for the experience of knowing their investments are falling in value on a seemingly daily basis. As former boxer Mike Tyson once said, “Everyone has a plan until they’re punched in the mouth.”
Those of us who pay attention to behavioral science have long known that the risk assessment tests given by many advisers to their clients were problematic. Tolerances for being able to withstand a drop in portfolio value vary over time. A typical investor taking a risk questionnaire in October 2019 and again in March 2020 would give different answers about how much downside they are willing to tolerate.
How you feel and how you act, of course, are two different things. We’ve seen this pattern with our Sentiment Survey and our Asset Allocation Survey. The swings in the weekly sentiment readings are much larger than the fluctuations in allocations.
Our surveys show AAII members to be less reactive than the so-called “smart money.” Individual investors are not responsible for causing the large swings in asset prices. Rather, it has been the trading firms with their ultra-short-term focus that have caused the big price moves. These firms are ultimately managing money for pensions, endowments and other large-money investors.
Regardless of whether you’ve reacted to the coronavirus bear market or not, it’s worthwhile to take the time to write down your observations now. Think about how you felt (and currently feel) and what you’ve actually done. Did you sell out of fear? Did you buy? Did you buy and then sell after seeing the price of the investments you thought were cheap get even cheaper? Did you do a Roth IRA conversion? Did you harvest tax losses while being careful to avoid the wash sale rules?
Don’t judge yourself; just be observant and honest. Knowing how you react in the face of adversity will help you determine how much downside volatility you can withstand. It may also prompt you to consider changing how you engage with your portfolio and your investments. Once the bull market comes back and stocks rise to new highs (the timing of which is admittedly uncertain as I write this), you can contrast your feelings and actions then with what you’ve felt recently. Somewhere in the middle is a happy medium you can be in.
Not only is this a good exercise to do, but it is also timely: April is Financial Literacy Month. You’ll notice several articles tied to the subject in this issue. Contributing editor Chris Pedersen illustrates how a portfolio allocated to target-date funds can be improved here. Fellow contributing author Craig Israelsen offers mutual fund ideas here for those who are just starting to invest. And here, your fellow AAII members talk about what they’ve done to get children and grandchildren started in investing. Read them and share them.
Wishing you prosperity and good health,
Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII
Editor, AAII Journal
@CharlesRAAII
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