Many people have weighed in on how to behave when the stock market takes a downward turn. To be sure, no one knows exactly when, why or how this will happen or how long it will last. That said, a serious drawdown certainly seems to be under way now.
To me, this poses a philosophical problem. On the one hand, no one can reliably time the markets or call market bottoms or anything of the sort. On the other, it is entirely possible that the recommended course of action would be different if we were to honestly reflect on what might transpire. Think about the following questions and write down your answers:
- How would you react to a 20-per-cent downturn, with markets only returning to their previous highs 12 months from now?
- How would you react to a 60-per-cent downturn, with markets only returning to their previous highs 12 years from now?
Were your answers to those two questions identical? To hear many financial people speak, the recommended course of action is always to stay the course and ride it out. Think long term. In this scenario, “long term” is seldom defined, but surely anyone using the term would say it means at least 12 months. There are three problems here:
First, no one knows how long a downturn will last. Risk tolerance can be thwarted by risk capacity (for instance, the need to withdraw money for income purposes) if you’re old enough. Think about this: There are plenty of “long-term” Japanese investors who still haven’t seen their stocks regain their 1989 levels. That’s more than three decades! No doubt, some of them may have had the legitimate psychological makeup to stay the course for 33 years. Unfortunately, many of them are dead now.
Second, no one knows how deep any given drop will be. Maybe you can endure 20-per-cent drops with no emotional problems. Maybe you can even withstand multiple drops of similar magnitude in quick succession. But if the drop is deeper than anything you or the people advising you have ever experienced, then there is no precedent and, therefore, no reliable way to anticipate your reaction. By definition, no one can reliably predict how they will react to something they have never encountered.
Third, owing to my first two points, no one knows in advance which version – a quick return to previous levels, an arduous slog with no apparent return to old highs, a garden-variety drop or a once-in-a-lifetime catastrophe – they will experience. When the drawdown starts, everyone needs to decide how to proceed without having a clue how everything will play out. In the immortal words of Whitney Houston: “How will I know?” The answer is simple: You don’t. I’m being trite, but the consideration is important.
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In short, the simplistic advice “Hang in there” is nice in theory but might not always work out too well. There’s an old saw that says: “The difference between theory and practice is that in theory there is no difference, but in practice, there is.” Investors and their advisers may say they can hang in there, and many genuinely believe it. My point is delicate, but critical. Most of the advice on offer right now is presumptive – and that’s dangerous. Telling people how they should react in a potential recession when they may unwittingly face a depression is like bringing a knife to a gun fight.
To be clear, I do not know what lies ahead. My observation, with great respect, is that neither does anyone else. If your answers to my first two questions were different and the advice you’ve been given (or are giving) presumes that what lies ahead is the first scenario when, in fact, it ends up being the second, then that generic, time-tested, standard bit of financial advice could prove disastrous. It may even be fair to say that well-intentioned, measured, benign counsel could be wrong.
The fact is no one knows, so the advice you receive should reflect that uncertainty. There is simply no definitive way of knowing what’s right or wrong before things run their course. That’s especially true from a psychological perspective, since people feel the pain of a loss twice as strongly as they feel the joy of a gain.
My personal view is this: People who advise their clients to “stay the course” without determining how much pain those clients can withstand, and how long they can withstand it, are acting as if they know the downturn will be modest. The only problem is they don’t know. Their advice should reflect this.
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