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Whew! What a week. Unless you’ve been living in a cave, you’ve likely heard about last week’s roller coaster ride on Wall Street. It all started the previous Friday night when Standard & Poor’s downgraded US government debt.
Once Monday rolled around, the stock market tanked. Then it recovered. Then it tanked again. And after that? It recovered again.
Amazingly, despite the volatility, the markets (depending on which index you were watching) closed down around 1.5% for the week. Not too bad, all things considered. But it could have been much worse if you lost your nerve and sold in a panic.
Riding the roller coaster
Let’s start by looking at some concrete numbers. These are the closing values of the Vanguard Total Stock Market Index fund (VTSMX):
- Friday, Aug 5th – $29.99/share (pre-downgrade)
- Monday, Aug 8th – $27.88/share (down 7.03%)
- Tuesday, Aug 9th – $29.29/share (up 5.06%)
- Wednesday, Aug 10th – $28.05/share (down 4.23%)
- Thursday, Aug 11th – $29.38/share (up 4.74%)
- Friday, Aug 12th – $29.53/share (up 0.51%)
Now let’s consider the case of a hypothetical investor with $10k invested in VTSMX at the close of business on August 5th. That works out to a bit over 333 shares.
Ready? Here we go…
As the market crashed on Monday, our investor friend panicked and sold his holdings. On Tuesday, as the market rallied in the late afternoon, he regretted his move and bought back in. But on Wednesday, the bottom dropped out and he sold. Then on Thursday, things were looking up, so he bought back in. By the time Friday rolled around, he was exhausted – and the market didn’t move much – so he sat tight.
Given that the market was down just 1.5% over the course of the week, would you care to take a guess how our investor friend fared? Believe it or not, he lost 10.52%!
While this is clearly an oversimplified, worst-case scenario with a number of flaws – not the least of which is that Vanguard’s short term trading policy would prevent you from buying and selling one of their funds like this – it helps to underscore an investing truism. If you make emotional decisions you can get wiped out.
Of course, we could just as well tell the story of an investor with cash in hand and remarkable timing. By buying on the dips and selling after the rallies, this story would be quite different. But honestly, which do you think is more common? For “everyman” investors to show uncanny timing and make a killing? Or for them to panic and get killed?
The point here is that you need to have a plan and stick to it. Trying to time the market is, for the most part, a loser’s game. For starters, you need to have a well-defined (and proper) asset allocation in mind. If you were unnerved by last week’s volatility, you might not be as risk tolerant as you thought.
Beyond having the proper allocation, you’ll need to periodically rebalance your portfolio to maintain this allocation, and you should also consider harvesting your losses for tax savings. And sure, if you have cash on hand, don’t be afraid buy a bit extra when the market is down.
But whatever you do, don’t lose your nerve and sell in a panic. If you do, you’ll wind up turning you paper losses into very real, and potentially devastating losses.