25 August 2015

The single most important piece of advice during a stock market crash: don't sell

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Most people on most days don't pay too much attention to the stock market or spend much time thinking about it. One big exception is on days when the market crashes dramatically. These days are very important to the financial press, and lead to a lot of media coverage about the market's decline. That necessarily leads people to develop a lot of negative emotions about stocks, and possibly motivates them to start checking their own 401(k) or IRA to see how much money they've lost. Negative sentiments, of course, tend to lead to an impulse to sell — or at least to stop buying.
Don't do it.
Selling off stocks during a crash is a terrible idea. While the urge to divest is understandable — the emotional equivalent of avoiding shellfish for a few months after a bad oyster makes you sick — it's also financially ruinous.
In the long run, the stock market has a pronounced tendency to go up, but it exhibits a lot of day-to-day and even year-to-year instability. The key to making money as an ordinary investor is to ride out those highs and lows and take advantage of the beneficial long-term trend. Yet studies show that most people fail to do this, with potentially catastrophic accounts.
People buy high and sell low
As we've covered in the past, actively managed stock portfolios where "experts" try to time the ups and downs of individual stocks get lower returns than passive index funds. What's less well-known is that, as Geoffrey Friesen and Travis Sapp have shown, individual investors in mutual funds get worse returns than the funds that they invest in. This is true whether the fund pursues an active strategy or a passive one.
The reason is that the decision about whether to invest in a stock fund (or how much to invest) is necessarily an active strategy, and people are bad at it.
Looking at the 1991-to-2004 period, they show that people have a marked tendency to buy into the market after hearing a bunch of good news about it (i.e., too late) and to sell after hearing a bunch of bad news (i.e., the worst possible time). The result is a 1.56 percent annual rate of underperformance. That's not a huge number, but it compounds over time. Across a 30-year period of working and investing, that 1.56 percent underperformance adds up to the typical person ending up with less than two-thirds of what she could have obtained by buying and holding.
Sell when you need the money
Rather than tying your stock market moves to your assessment of market conditions, the right thing to do is make saving and dissaving decisions based on your family's actual financial circumstances.
If you are working and things are going basically okay and you're not planning to retire for a little bit, you should be saving a substantial amount of money, and the stock market is as good a place as any to put it. The time to sell is when you need the money — when catastrophic expenses or job loss strikes and you have no choice, or when you're nearing retirement and need to start planning for how you are going to save money.
Some people are going to find that the times in their life when they need money correspond with periods when the stock market is unusually high. Those people are lucky. Being blessed with good luck is always a good investment strategy. But trying to make your own luck by timing the market is unlikely to work, and letting yourself get excessively swayed by the ups and downs of the headlines is certain to fail.

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