The United States officially entered a recession in February 2020, ending the longest economic expansion in American history. The contraction in March 2020 was so severe that the National Bureau of Economic Research declared a recession in June, without waiting for a second complete quarter of negative growth.
The prevailing wisdom says that investors should hunker down and ride out market declines. In reality, a noteworthy portion of investors sell off their holdings when markets fall, fearing further loss. Earlier this year, I had a family member call me and say “I know you told me not to cash out, but I did. What do I do now?”.
My family member was far from the only one to sell off when the market fell. According to Morningstar, spooked investors pulled a net $326 billion from mutual funds and exchange-traded funds in March. For most of those investors, that money remains out of the market.
If you were one of the investors who sold out earlier this year, you may be wondering why selling out was likely the wrong choice and how and when to get back into the market.
Why Is Selling Out Likely a Bad Idea?
A well-diversified portfolio is designed to handle market volatility while still trending towards long term gains. Whereas a painful short-term loss may be unavoidable in a market-wide crash, diversification works to prevent losses from which your portfolio may not recover.
Moving to cash can seem like a prudent move to stem further losses when the market rapidly drops. However, holding a large portion of your assets in cash may be a poor choice for most investors. Cash can be a difficult allocation because:
- Interest rates are historically low. The Federal Reserve has kept interest rates low since the last financial crisis in 2009. The current rate is near zero which means that cash holding like bank accounts and short-term money market funds are earning less than the rate of inflation. Anytime your savings grow at less than the rate of inflation, you are effectively losing money.
- Holding cash means missing out on market gains. The S&P 500 closed at a record high on August 18, 2020 and surpassed that high on September 2, 2020, erasing the market losses early in the coronavirus pandemic. Investors who pulled their money from the market in March endured the market plunge without the relatively rapid market recovery that followed.
How is the Stock Market Recovering Faster than the General Economy?
The economy and the stock market do not move in tandem, even in normal times. The economy is concerned with what is going on right now and in the recent past – higher unemployment, Main Street small business closures, and ongoing lockdowns to control the spread of the coronavirus. Economists look at historical data from the trailing one to three months to determine economic health.
The stock market is inherently forward-looking. Investors look at current conditions – of the economy at large and of the financial health of the consumer and of corporations – and estimate pricing for stocks today based on predictions for the future (typically three to six months in advance).
The market has benefited from Fed policies of low interest rates and a continuation of its quantitative easing approach of injecting liquidity into the financial system by purchasing treasuries, mortgage-back securities, and, recently, corporate bonds. These policies make holding assets in cash unappealing and are designed to drive investors into the market.
The stocks making the largest gains – big companies like Amazon, Google, Facebook, Netflix, etc. – have been largely protected from the current economic conditions. White collar workers can work effectively from home. Online ordering, video streaming, and social media all benefit from consumers sheltering in place. Companies like these dominate in the stock market, pushing the market up at the same time that small businesses are closing their doors.
Waiting for a full economic recovery before putting your money back into the market will likely mean missing out on significant gains.
When and How Should You Get Back In?
The best time to start investing again is almost always “now” – no matter when now is. The perfect is the enemy of the good. Trying to time the market to put your money back in at a hypothetical perfect time is a fool’s bet for most investors.
To reenter the market, you have two options:
- Put all your money back in today. Stocks rise more often than they fall. Putting all of the money you have waiting to invest into the market today offers the greatest possibility of profit. However, this is a higher risk option – if you are unlucky with your timing, the market could theoretically fall again the day after you invest and stay low for a long period of time. Investors who pulled money out of the market in March 2020 are likely to have low risk tolerance and may find this method too emotionally draining to stomach.
- Reinvest slowly with a dollar-cost averaging strategy. Dollar-cost averaging involves investing a predetermined amount at regular intervals into target assets (regardless of fluctuations in their pricing). If you invest a portion of your paycheck in a 401k plan, you are already utilizing dollar-cost averaging. The same dollar amount is invested in the array of assets you have chosen each month, regardless of the price of any given asset that month. Dollar-cost averaging allows investors to minimize the impact of short-term volatility and avoid the risk of investing a large sum of money at an inopportune time.
Investing in the stock market will always carry some degree of risk. However, as you now know, holding large amounts in cash carries its own risk in losses to inflation and opportunity costs. Before reinvesting your money, make sure you understand that market investing is a long-term game and are prepared not to make the same mistake of selling out should the market fall again. Finding an investment strategy that you can stick to long term, through ups and downs, will allow you to feel good about how your money is working for you no matter how the larger market and economy are doing.
What Should I Do Differently Next Time?
A trusted Financial Advisor can help you re-enter the market and make a plan for the next downturn that focuses on your long-term goals. Having a good Financial Advisor on your side is particularly useful in down markets and times of heightened volatility. Do-it-yourself investing is relatively easy when everything is going up and looks to be going that way for a long time.
When the market is more volatile – say with a global pandemic – a Financial Advisor can help you find the right investment strategy for your financial needs. If you are nearing retirement or will otherwise need to draw down your assets in the short- or medium-term future, a Financial Advisor will help you navigate balancing risk and reward to ensure that you have income available when you need it.
The best Financial Advisors bring education and experience to the table and are able to review your investments without their judgment being clouded by emotion or fear. It’s undoubtedly scary to see your investments shrink when the market turns down. A Financial Advisor can help you see the opportunities from holding on to an investment long term and can help you find areas to invest that take advantage of the lowered pricing. If you reframe your thinking of a market downturn as a sale on stocks, you are less likely to want to flee the market and more likely to be willing to snap up some bargains.
