Sometimes, standing still takes the most courage

Posted by on August 9, 2011 @ 8:25 am in Investing

Investors have every right to feel anxious about the markets.

First, we had the endless drama and squabbling over the federal debt ceiling. An agreement was reached, but before we could take a collective sigh of relief, the equity markets tumbled more than 4% last Thursday amid mounting concern over the fiscal health of several European countries. Late the following day, S&P downgraded its rating on U.S. debt from AAA to AA+ status. We worried over the weekend, and on Monday volatility was in full force, and the equity markets gave up another 6%. It’s enough to make any investor cry “uncle.”

On top of it all, the media continues to stoke investor concerns with round-the-clock coverage. Much of the coverage is informative, levelheaded, and entirely fair. But there’s also an increasing amount of media noise that can cloud even the most disciplined investor’s thinking. During my drive into work yesterday, a national news correspondent referenced “the five stages of grief,” suggesting that perhaps we’ve all been in “denial” about our nation’s debt situation, and that the S&P downgrade will force us to enter the next stage—”acceptance.” It’s no wonder investors are on edge.

In times of increased equity market volatility—regardless of the events driving that volatility—some investors feel compelled to flee the equity markets, to “sit this one out” until things settle down. It’s a natural reaction, but often the wrong one. Through all sorts of market events, including the global financial crisis in late 2008, historical data proves the wiser course of action may be to do nothing. Trust me—we at Vanguard know this advice can seem awfully passive to investors who are anxious to protect themselves.

While rushing to a “safe” asset like cash in the face of significant stock market volatility may assuage your immediate fears, it may introduce a different type of risk to your portfolio—one the media largely isn’t talking about.

Before you make any drastic changes to your equity allocation, consider what’s known as shortfall risk. It’s the possibility that your investment portfolio will fail to meet your long-term goals. To be blunt, dumping stocks in favor of cash can leave you exposed to shortfall risk over the long term. Even if you manage to get out of the market at the “right” time (and many are either too early or too late on that call), how will you know the precise time to get back in? Most investors don’t move to the sidelines with the intention of staying there indefinitely. Yet many flounder in reestablishing their equity positions for fear of making the wrong call twice. Inertia sets in and before you know it, a relatively young investor can be unwittingly holding a portfolio that’s far too conservative for his or her time horizon long after the bulk of the rebound has occurred.

Vanguard research shows that the best days in the equity markets have often closely followed the worst days. To demonstrate this point, consider that the S&P 500 Index dropped –7.62% on October 9, 2008. Just two trading days later, on October 13, the index rebounded +11.58%. Similar patterns held true for the index’s best and worst trading days in 1929, 1932, and 1987. You have to be in the market to participate in a rebound, the lion’s share of which can occur over the course of days or weeks rather than months. Unfortunately, investors who rush to the exits in times of volatility often miss out on a significant portion of the market’s recovery.

As I write this, things aren’t looking pretty in the equity markets. By the time this post is published, the markets might be up or down—who knows? One thing you can probably count on is continued volatility in the near term. Either way, I’m certain the media will find lots to say about it.

What you probably won’t hear much about is the wisdom of standing still—of revisiting your asset allocation, reaffirming your risk tolerance, and remembering that investment strategies play out over the long term. It may sound quaint, but doing nothing might just make you one of the smartest investors yet.

Note: All investments are subject to risk. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

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