This is a refrain we've heard from time to time over the last few years.
As the bull market continues to push higher, investors are wondering if a stock market crash is coming and some have defensively moved their cash from the market to the sidelines.
At first, this logic makes sense. If it seems like stocks are overvalued or there is an upcoming economic threat on the horizon, why not jump out now and avoid the crash?
A stock market "crash" can be defined as a "correction" (a 10%+ decline in market prices from a recent high) or a "bear market" (a 20%+ decline in market prices over a two-month period).
Before we cover the research, there's one big caveat: You should never invest money in the market that you may need to use in the next 5-10 years.
Over the last 90 years, the stock market has created incredible wealth and the general trend has been a steady march upwards. If you simply held through every selloff, correction, depression, and bear market, you would've done incredibly well. Over time, the U.S. stock market has followed the U.S. economy and delivered a trend of upward growth.
However, when you zoom in on the short term that steady upward march has seen many volatile pockets where markets have declined significantly, even catastrophically, at times.
If you were fully invested during one of these downturns and simply held through it, you probably recovered and continued to gain over the next 5-10 years (more true after 1975 than before). But if you needed your invested cash for something outside of investing, you may have found yourself forced to sell out of your positions for a large loss.
Take for example the most recent crash of 2008 - 2009. The S&P 500 declined roughly 55% from its peak during the selloff, hitting a low point in March, 2009. If you were planning to buy a home or retire in 2009, you were devastated.
Over half your money was gone.
However, if you just held on, you would've made back your money within a few years (by early 2011), and then a lot more through the record-breaking bull market that followed.
And if you had continued adding money to your investments at bargain prices throughout the market crash you would've recovered even faster.
So the big caveat is this: You should only invest money in the market that you won't need for the next 5-10 years and could keep invested through a downturn.
So if, for example, you're planning to buy a home or retire in the near future, you should look carefully at how much you keep invested in the market compared to how much you expect to need in cash.
It's Incredibly Difficult to Avoid a Stock Market Crash
OK, so assuming we're only investing money we won't need in the near future and could stand leaving in the market through a stock market crash - should we try to time the market and avoid an upcoming pullback?
Research suggests the answer is "No."
There are two big reasons why it's not a great strategy to try and avoid a possible stock market crash:
- It's really hard for the average investor to do successfully
- Missing out on a possible rally by putting cash on the sidelines can really hurt your long-term returns
First of all, why is it so hard to time the market? It's really tempting to look back at crashes and think, "Well if I had just sold right there, then I would've avoided the whole downturn."
Hindsight is 20/20. But it's never that clear in the moment that a true market crash has begun.
In 2016, quantitative research investment firm AQR published an interesting paper
on using market timing to avoid crashes. Looking back at 115 years of market data, they found that selling out of the market based on indicators of market overvaluation had failed to beat a passive buy-and-hold strategy, especially over the last 60 years.
AQR concluded that timing the market based on a mix of value and momentum indicators might work better, and that savvy quantitative investors could try to use a quantitative blend to "sin a little" when it comes to market timing.
So one of the top quant-based investment firms basically concluded that maybe if you're good at quantitative analysis you could try to time the market a little. But overall, timing the market based on valuation metrics is not a good strategy.
Looking at it from another angle, the CXO Advisory Group ran a study
to determine how good financial "gurus" were at predicting the direction of the market. From 2005 through 2012 they collected 6,582 forecasts offered publicly by 68 experts, bulls and bears employing technical, fundamental, and sentiment indicators.
Overall, they found the accuracy of these gurus to be roughly 47% - meaning these expert forecasters were wrong when predicting market direction more often than they were right.
Even the seven best gurus were right only 60% - 68% of the time. Statistically speaking, being right that often is actually very impressive (and very lucrative). But it's a short sample period and some gurus are likely to be right more often than others just by chance. It's not clear their predictive abilities would stand the test of time and several different market declines.There are other examples, but these two underscore our first point: It's not clear that anyone (even the experts) can successfully know when, exactly, is the right time to sell.
Granted, there are always exceptions. If you're a day trader or swing trader who has made a living at moving in and out of positions by reading market technicals, you may be able to profit by timing the market.
We wouldn't want to discourage anyone from trying to profit from market timing by saying, "it's impossible." In fact, it's probably very possible to do well.
But for your average (or even advanced) stock market investor, who has a limited amount of time, energy, and research tools to execute such a complex investing strategy, correctly timing the stock market is likely to be very difficult.
In fact, history suggests the average investor makes market timing decisions based on emotions and headlines, rather than thorough technical analysis. It's these emotion-driven decisions that can drive us to buy high ("Everything keeps going up, I've got to get in!") and sell low ("The market keeps crashing, I need to get out now!").
Missing Out on Stock Market Rallies Can Devastate Your Profits
But OK, even if I don't know exactly when a selloff is coming, can't I move to cash now because I'm pretty confident there will be a correction in the somewhat near future?
This brings us to our second point: By pulling cash out of the market to try and avoid downturns you can miss out on big rallies, which really hurts your long-term returns.
Or, to quote legendary investor Peter Lynch, “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
Most of the stock market's gains tend to be delivered in small pockets of concentrated strong performance. If you happen to be sitting on the sidelines waiting for a pullback during some of these pockets of performance, you can lose out big time.
The Cogent Advisor shared a relevant analysis
. They looked at data for 91 calendar years (or 1,092 months) of U.S. investment returns over the period 1927 through 2016 and found:"While the average month returned 0.95%, if we eliminate the best-performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1%). In other words, 8.5% of the months provided almost 100% of the returns.
The best-performing 91 months, an average of just one month a year, earned an average return of 10.5%.
While the average quarter returned of 3.0%, if we eliminate the best-performing 91 quarters, the remaining 273 quarters (three-fourths of the time period) actually lost money, providing an average return of -0.8%. In other words, just 25% of the period provided more than 100% of the returns.
The best-performing 91 quarters, an average of just one quarter a year, earned an average return of 14.3%."
Similarly, Calamos Investments analyzed
the 20-year period from 1996 - 2016 and found that missing just the 10 best days of performance during that period would cut your total returns in HALF.
In addition, by sitting out of the stock market in cash, you would miss out on the income from divided payments which could be pocketed or plowed into buying more shares while they're cheap.
We've heard this same mantra from other smart and experienced investors as well. Looking back at their performance record, the cost of missing out on rally opportunities by having some or all of their cash on the sidelines ended up hurting them more than they gained by avoiding any pullbacks.
"Stay as Fully Invested as Possible: Empirical research has shown that 80%–90% of investment returns have occurred in spurts that amount to 2%–7% of the total length of time of the holding period. The rest of the time, stocks’ returns have been small.
With stocks, you have to be in to win. We believe that value-oriented stocks with extreme investment characteristics are likely to beat the returns from cash over the long run.
Index funds stay fully invested with no cash. The long-run odds of having your portfolio generate returns in excess of returns from fully-invested index funds are enhanced by keeping cash to a minimum and staying as fully invested as possible.
Note: It is a little painful for us to write this section because, in our past, we often sat on our thumbs with too much cash in clients’ portfolios before empirical research and our own analysis convinced us of the error of our ways.
We were not knowingly market timing, but were overdiversifying: Instead of investing 3% of portfolios in a perfectly good bargain stock, we invested 1% because we wanted to buy more at even lower prices. Cash, and lower investment returns, were the residual of this process.
Over the last 22 years, the after-fee return on the portion of our clients’ portfolios invested only in stocks (not cash), 21.4%, beat the return on cash, 7.1%, by 14.3% per year."
Indeed, it's telling that there seems to be much discussion on the topic of stock market timing during 2016 and 2017, when investors often felt the bull market couldn't possibly go much higher.
But who could have anticipated that the S&P 500 would rally another 42% (including dividends) from November 9, 2016 (the morning after President Trump won the U.S. presidential election) through September 21, 2018 (the date we wrote this article)?
If you had moved to cash out of fear of an upcoming stock market crash (as some investors did in 2016) you would've missed another 42% upside.
Watch for Upcoming Recessions
While we don't believe in market timing, we do have one important distinction to our "don't try to time the market" rule:
Watch out for recessions on the horizon.
How is that different than market timing?
When most investors are market timing, they're trying to perfectly time small gains and declines in the market, usually based on nothing more than emotion and market movement. This approach is destined to fail.
What we practice is recession forecasting, which involves using robust economic data and forecast modeling to spot upcoming recessions and adjust our investment strategy accordingly.
We explain the difference between market timing and recession forecasting, as well as how to play defense (avoid losses) and offense (earn profits) during a recession in great detail in these two lessons:
What Should You Do During a Stock Market Crash?
So if you're holding stocks and the market starts to sell off, what can you do?
Here our research shows that actively managing your portfolio can make a big difference. As the market sells off, it's important to make sure you're always positioned in the absolute best stocks for your investment goals.
Market crashes are often accompanied (and driven by) underlying changes in the U.S. economy. It's important to make sure you're owning stocks that are adapting as well as possible to these changes.
For example, if you owned a prominent banking stock in 2009, it likely became clear at some point that the company was going to continue to struggle (from a financial, operational, perception, sentiment, and regulatory perspective) for years to come as it dug out of the mortgage mess. Perhaps it would be better to rotate into a tech stock (say, Google GOOGL) or a medical stock (say, Pfizer PFE) which was more insulated from the banking disaster.
In other words, read the field and adapt your strategy accordingly.
A side advantage of this kind active turnover during a stock market crash is that it can create capital losses which can offset your capital gains (and income) taxes for both present and future years.
Each stock market crash is different, but the underlying point remains the same: You always want to own the absolute best stocks in your portfolio and you should always be evaluating your holdings based on how good they are compared to attractive alternatives. This is especially true during a stock market crash when company fundamentals are changing much more rapidly than during a steady period.
Based on our experience and research, owning a well-crafted portfolio of the best stocks will take you further than trying to time the market and avoid a possible stock market crash.
Buying the Best Stocks is Your Best Defense Against a Stock Market Crash
While there's much more research available on the topic, we'll summarize here:
Knowing when to enter and exit the market is hard. Really hard.
Even the best can do it only modestly well, some of the time. And missing out on even a handful of big rallies (which often come after big declines) can devastate your long term returns.
So in our opinion, the best strategy is to make sure you're only investing money you won't need in the next 5-10 years, and then leave it fully invested, rebalancing frequently into the best stocks for your goals.
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