What To Do In A Falling Market

The global equity markets have been increasingly turbulent over the past few weeks. After peaking on May 21st, the S&P 500 fell in June by more than 5%, and emerging market equities have declined by over twice that amount.

Many of our clients are asking us: “What should I do in a falling market?”

There are three rational actions to take in response to a falling market, actions that research shows will serve you well in the long run: Keep investing. Rebalance. Harvest your losses.

But investors aren’t solely rational. They’re human: When there is turbulence in the markets, people typically have one of three emotional responses.

• You want to sell everything in an attempt to “limit” the loss.

We talked about this fear-based response to the market’s movements last week. If you’re feeling this fear now, you may be extrapolating from the past few weeks of declines forward to the next few weeks or months. But no one can predict the market. Selling to limit your losses is merely market timing by another name – and trying to time the market is investors’ most serious mistake, as our CIO, Burt Malkiel, wrote.

When individual investors try to time the market they are much more likely to buy and sell at the worst times. Emotionally, investors suffer great pain when pessimism is rampant and stock prices fall. They are more likely to buy when everyone is optimistic and prices are near or at their peak.

Investors who try to time the market end up, on average, in the worst of both worlds: selling low and buying high.

• You want to close your eyes and avoid looking at the numbers.

This isn’t a terrible response. Even during the biggest market collapse in recent history (2008-09), holding the same set of investments through the crash and rebound would have resulted in a return to previous levels, five years later. This chart tells the tale.

• You want to be opportunistic and buy.

If you act rashly on this emotion, you may end up making a mistake, buying so much that you throw your asset allocation off. But it’s great to be comfortable acting in a non-conformist way as an investor — buying when everyone else is selling. Just apply some of the research and rational thinking that we’ll share below.

A little context goes a long way

First, a little perspective before you take any action at all. When the media shows you a chart, they are usually adjusting its scale to help their ratings. The chart for this month looks a little scary:

SP500June Down

 

The same month looks a lot better if you extend the chart’s scale over six months.

SP500 Monthly Down

What should I do?

If you want to take advantage of the market decline, the easiest thing to do is keep investing. If you are in the midst of a regular investment schedule, as many of our clients are, you are taking advantage of the market’s dip through dollar-cost averaging, or regularly scheduled deposits. The other two ways to take advantage of the falling market are to rebalance and to tax-loss harvest.

Rebalancing your investments maintains your asset allocation – the allocation that is designed to help you meet your long-term goals. While many services rebalance only at fixed time periods – the end of the quarter or the end of the year, research shows that rebalancing based on deviation from your ideal portfolio, not time, yields better results.

If you rebalance regularly, you sell assets that have gone up a lot in value and buy those that have not gone up as much or have gone down.

If you rebalance regularly, you systematically buy low and sell high.

The net effect is simple: over time, you systematically “buy low” and “sell high”. Rebalancing works because, over time, different assets move in different amounts relative to each other.  Not everything goes up or down by the same amount at any given time.

The result of rebalancing is lower volatility and, often, better returns over time. Burt and noted investor Charley Ellis found in their book Elements of Investing that from 1996 to 2005, rebalanced portfolios generated average annual returns of 8.46% vs. 8.08% for those that were never rebalanced. The rebalanced portfolios had less volatility (standard deviation of 9.28% vs. 10.05%) than the portfolios that were not rebalanced.

Tax-Loss Harvesting is a more sophisticated way to take advantage of volatility. By selling assets for a loss, you gain the opportunity to use that loss against other gains for the year on your annual taxes. A similar asset is purchased immediately so that you can participate in any market rebound.

The Wealthfront approach

Wealthfront automatically rebalances and harvests tax losses based on the type of account you hold with us, and thresholds established by our software. In the past six weeks, we have performed thousands of rebalancing & harvesting trades across over our clients’ portfolios.

Falling Market Graphic

 

At Wealthfront, we’ve provided the optimal automatic services to help our clients make the most of turbulent markets:

• Automated deposits and investments ensures that you continually invest, regardless of short-term market movements.

• Automated rebalancing ensures that regardless of which day of the year is good or bad, your diversified portfolio will take advantage of market gyrations to buy low and sell high.

• Continuous tax loss harvesting allows you to take advantage of short-term drops, saving money on your taxes, while maintaining a well-balanced, diversified portfolio throughout the year.

When markets are falling, the key is not to ignore your emotional reactions, but to channel them into strategies and actions that will improve your long-term results.

Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

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