What to do in a market downturn?
2022 was a down year for the market. During the one-year span from December 31, 2021 to December 30, 2022 the S&P 500 (stock market index tracking the performance of 500 large US companies) was down 19.44%. Bonds performed poorly too. The return on the S&P US Treasury Bond Index was negative 10.7% in 2022. The return on bonds issued by S&P 500 companies was negative 14.2%. What about cash? With inflation from 2021-2022 hovering around 7.48%, holding cash was not great either.
The most important rule in a down market is to avoid panic selling and creating what’s referred to as the Behavior Gap in your portfolio. The Behavior Gap refers to the difference between the rates of return that investments produce when an investor makes rational decisions based on their long-term investment strategy and the rates of returns investors earn when they make choices based on emotions. Creating a Behavior Gap is so common that a field of study called Behavioral Finance exists to better understand how psychology influences financial decision making.
Behavioral finance experts at Oxford risk concluded the following:
1) If you panic and sell, by turning paper losses into real losses during a downturn you can underperform by 4-5% year.
2) If you panic sell, you’re ‘selling low’, and since no one can time the market, you don’t know when to get back in.
3) Most people sit their cash on the side lines then buy back into the market when the market has gone up, ‘buying high.’
What if you’re retired and need the money that you’ve invested to live on, or you need to pay for an emergency and the markets are down? You don’t want to thoughtfully avoid the Behavior Gap, only to be forced to sell your investments when the market is down.
When building a portfolio one way to avoid taking unnecessary market losses during years like 2022 is to implement what’s referred to as ‘The 3 Bucket Strategy’.
Bucket 1: Emergency Savings and Liquid Assets
Even with high inflation, having cash available to cover one to two years of living expenses means you don’t have to sell investments at a bigger loss than the rate of inflation in a down market. You can pull from this bucket to shore up your expenses while the market recovers.
Bucket 2: Medium-Term Holdings
This bucket exists to earn you interest and dividends. Bucket 2 is targeted for medium term goals. You can afford recovery time from a down market before you need to sell these assets. You have some tolerance for risk and loss with these holdings and have filled this bucket with dividend stocks, corporate bonds, long term CDs, Treasury Notes, I-Bonds, etc. Ideally you pull from Bucket 2 to refill Bucket 1 when the market improves.
Bucket 3: High-Risk, Long-Term Holdings
Bucket 3 is for long term investments of 10+ years. When times are good you can sell from Bucket 3 to fund Bucket 2. Large growth stocks, small cap value, emerging markets, REITS and higher risk bonds belong here. While Bucket 1 is refilled by bucket 2, and bucket 2 is refilled by bucket 3, bucket 3 refills through the earnings of its investments and any new money you continue to invest.
There is no one size fit’s all for everyone when it comes to investment strategy but by understanding these concepts you can reduce your chance of realizing significant losses during a market downturn.