The Risk of Playing It Safe

At a rudimentary level, investing in the stock market seems like the simplest, most straightforward thing to do:

1. Sell your stocks when you expect the market to drop.

2. Wait in cash until it’s safe to get back in.

3. Reinvest at lower prices than before the fall.

It’s simple, right? When the market appears too risky, sell. Your timing may not be perfect, but at least you’re not left holding the bag. No more sweating the market. But don’t give in to the siren call of market timing. It can often result in selling low and buying high – the opposite of your intent.

If you sold near the market’s bottom — and a surprising number of people do — you’ve already lost. In this instance, psychology works against you. If the market continues to fall, that confirms you’re a good judge of risk, right? Your confidence rises, along with your comfort in sitting out. However, markets can fool you.

During the 2008-2009 bear market, the S&P 500 Index fell 57% over 188 trading days. During that time, there were five so-called “bear market rallies.” The market rose significantly, once by 24%! Each rally was a false hope. The market soon resumed its plunge. Remember how well you judged risk? You won’t take the bait. You’ll wait until the bear market is stone cold dead. Unfortunately, the end of the market’s fall can only be confirmed months later. In addition, the bull market recovery is erratic.

During the bull market following the March 6, 2009, bottom, prices fell 5% multiple times, 8% twice, 16% once, and finally almost 20%. Fear of loss took you out of the market, so you’re cautious as you wait for proof it’s safe. Each drop confirms your suspicions. After all, at the beginning of that bear market, prices fell nearly 20% in only five trading days.

Trends can reverse quickly, and you don’t want to get back in prematurely. Markets bottom in the middle of recessions, not at the end and the market anticipates recoveries before they start. But most investors going to cash won’t join possibly false rallies until the economy is clearly recovering. However, some of the biggest gains happen early in bull markets when it’s still scary.

In March 2009, the market rose 23% in just a week. The recession didn’t end until 3 months later. Missing just the 10 best days during a 20-year period (1 of every 400 trading days) can reduce your average return by 40%. Those days have often happened when the economy is still bleak. The fear that took you out keeps you from getting back in precisely when you should. It’s nearly impossible for even the best investors to overcome a 40% deficit.

We believe it’s better to stay invested in strong companies that have survived, even thrived, during many dark days. Only then can you benefit from those big days that come without warning.

Because you can’t catch them from behind.