It was only a few short months ago that we feared intransigent policymakers would cause the economy and markets to hurtle into the abyss. I always preferred the term taxmageddon over fiscal cliff because it more accurately captured the pervasive sense of apocalyptic, foreboding doom, but it never really caught on.
At the time, the media was awash with opinions and strategies on how investors should deal with the imminent crisis. Thanks to my position at Vanguard, I had a firsthand view of how our clients attempted to manage the uncertainty. Understandably, with the wrenching experience of the 2008–2009 crash fresh in their minds, many clients didn’t want to experience another downturn in the markets if they felt they could do something to avoid it.
Our messages at the time: Don’t try to predict the future. Don’t let short-term worries alter your long-term strategy. This was quite different from the view of many pundits, likely because simply stating “stay the course” rarely makes for compelling television. Our clients seem to have found our perspective, expressed in articles on vanguard.com and reinforced by guidance from Vanguard representatives, extremely valuable and were reassured that dramatic portfolio changes weren’t the solution.
So, what happened? A deal was ultimately reached, and the worst-case scenario of across-the-board tax increases and spending cuts didn’t occur—although, as we all know, many critical questions about fiscal policy were left unanswered. Meanwhile, markets rallied for much of the first quarter, up roughly 10% year to date.* So, if you took some commentators’ advice (e.g., “take gains now” or “get out of stocks”) and reacted defensively by reducing your equity allocation for reasons other than those related to your long-term goals, you’ve missed out on a period of significant growth.
Which leads me to offer a few additional thoughts:
Often it’s best to tune out the noise and go for a walk. The best way to avoid the noise and fear that may lead you to make impulsive portfolio decisions is to ignore TV talking heads and do something healthier or more enriching. This is generally true even if there’s no crisis.
Rarely should taxes be the primary driver of investment decisions. Predicting tax policy now and into the future is no different from trying to time the market. Taxes are an important consideration into your long-range plans, but more relevant to how you allocate savings between taxable and tax-advantaged accounts. We believe having the long-term discipline to maintain a desired allocation with low-cost investments is far more critical to your investment success than successfully anticipating tax rates.
When tempted to react to short-term market uncertainty, ask yourself, “what if my prediction is wrong?” As the “fiscal cliff” approached, some of our clients wanted to make investment decisions based on what they were absolutely convinced was about to occur. Our reps asked the clients to pause to consider how they would react if those predictions did not come to pass. This proved to be a valuable reality check clients needed to force them to weigh the potential downside to decisions that would fundamentally alter their long-term investment strategy. (Lately, I find myself thinking about this when I hear pundits telling investors to “get out of bonds” because of an “inevitable” fixed income crash. While we certainly agree that the long bull market for bonds won’t last forever, this sort of advice ignores the important diversification role bonds can play, and doesn’t take into account the likelihood that bond income would increase if—and when—interest rates start to rise.)
The point isn’t that Vanguard was “right” about what was going to happen; in fact, we were very clear that we couldn’t predict what was going to occur. The lesson is that what often seems obvious as the “smart” thing to do in the short term is often counterproductive to your long-term investing goals.
*S&P 500 Index between January 1, 2013 and April 22, 2013. 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.
Note: All investing is subject to risk, including the possible loss of principal.