Why and when would you keep money out of the stock market
Previously, I said that it is extremely difficult to figure out when you should be invested in the stock market and when you’d want to be out. Generally, while risky investments like stocks tend to perform worse in recessions, it is very hard to know ahead of time when the economy is going on a downturn. Currently, talks of trade wars make the headlines of economic news. However, it is impossible yet to predict where these will end up. In the financial media, negative news has always been very present, most of which historically do not turn into an actual economic recession. A big risk is that you might get spooked by these and sell out of the stock market, therefore crystallizing your losses, only to then watch it go up, jump back in, see the markets swoon at the next scary headline, get out again, repeat… The stock market has usually rebounded from negative headlines that were not accompanied by a recession. So, it is better to stay at least somewhat invested in risky investments such as stocks and weather their volatility.
However, there are also very reasons to have at least some money in low risk investments like high quality bonds. There are 2 important considerations in determining how much you should invest in stocks and other riskier investments versus in safer investments like bonds or Guaranteed Investment Certificates(GICs): 1) when will you take out your money; and 2) how you react to volatility. The first, and slightly more important, of these two is the amount of time you have until you need your money, or your time horizon. For instance, if you’re investing for your retirement and it’s over 20 years away, you can afford to put most of your money into stocks. Stocks have tended to deliver higher returns over long periods of time, despite the times when they fall significantly. So, it is important to have a high proportion of money invested in the stock market if you’re saving for an objective that is still far away. On the other hand, if your objective is relatively close at hand, then you should have more money into safer assets like high quality fixed income. That’s because stocks often go down, sometimes by very large amounts. The worst market downturns have seen equities plunge by over 50%. Imagine losing over half of your child’s education savings just a year before they head to university. Furthermore, the stock market has sometimes taken a few years to get back to where it was previously. And even though such huge losses happened a few times, declines of 10% or 20% are far more frequent, often enough to be an important risk. Generally, if you’re saving for a goal that is just a few years away (say, 5 years or less), all your money should be in high-quality bonds or GICs. For longer-term objectives, you should have at least some of your cash in riskier assets like stocks.
Source: Guggenheim Investments
That said, the second factor introduced above, how you feel when your portfolio goes down, is almost just as important. While you should invest most of your money in high-risk investments for the long-term, these are also more volatile. As I mentioned, the stock market will have strong movements both up and down. The risk here is psychological: when stocks go down, investors can be scared in getting out of the market and run to safer assets; when they go back up, fear of missing out causes investors to jump back in. Just like reacting to negative news, there is a risk of locking in losses and missing subsequent rebounds. In their research study “Mind the Gap”, annually updated, the research firm Morningstar shows that investors in stock funds in the U.S. did not make as much money as the funds they invested. They tended to switch from bond funds to stock funds after the latter had a stretch of good performance and vice versa. Also, the more volatile funds in each category tended to have the largest gap between investor returns and fund returns. On the other hand, investors made more money by being in balanced (or allocation) funds than these funds themselves made. These funds, which have both stocks and bonds in them, tended to mute the performance extremes of these major asset classes, therefore inducing generally better behaviour from investors. A portfolio with a combination of both equity and fixed income is probably easier to hold for most people than a portfolio with just stocks. In conclusion, it is important to first arrive at an appropriate portfolio mix based on your objectives. If you’re looking far ahead, you should have more money invested in risky assets as they tend to produce better returns over time. Secondly, you can slightly dial down your risk if the inevitable ups and especially downs in the stock market make you nervous. Afterwards, you should stick to your objectives through the thick and thin as much as possible. There are numerous options available, some very low cost, for getting the right mix of assets for a do-it-yourself approach. If you think you need help or support, especially in times of high volatility, a good advisor should be able to provide guidance.