Waiting until the market "calms down"

Michael James has updated his Market Timer Breakeven Date. This is an amusing way to measure the futility of selling the TSX index and trying to buy it later at a lower price. For anyone who did their selling later than October 6, their decision to sell has lost them money compared with staying invested. October 6 was fairly early in the Great Recession, so this kind of market timing would have required substantial clairvoyance foresight just to break even.

This is a concrete example of a case where market timing failed to produce any improvement over buy-and-hold. But, after all, it is only a single example. Isn't it usually a good idea to to sell stocks when they're crashing, and wait for the market to "calm down" before buying back in?

The answer is definitely no. This does not make sense, and if you feel the need to do this, you are either acting irrationally, or you have a poor asset allocation that does not match your financial needs or appetite for risk. The reason for this has to do with the concept of Risk Premium.

The risk premium means that, quite rationally, an investor will demand a better return from an investment with higher risk. If two investments have the same expected return, and one has lower risk, nobody buys the other.

Of course, the stock market as a whole will naturally seem riskier whenever stock prices drop. Therefore, we can expect stock prices during a crash to drop more than the fundamental value of those stocks. If economic conditions make it likely for a company's earnings to drop by 20%, we should expect the stock price to drop more than 20%: specifically, 20%+X, where X is the additional risk premium.

The risk premium makes it a particularly bad idea for investors to wait until the markets "calm down". If "calm down" means lower risk, then these investors are specifically waiting until the risk premium disappears! Combine this with the fact that the market's estimation of risk subsides only when stock prices rise, and you will find that waiting for markets to "calm down" is an ideal way to sell low and buy high.

So am I saying that people should not sell stocks while the market is crashing? On the contrary: if they need the money soon, and it's tied up in stocks, people most certainly should be selling them. The sooner, the better. What I'm saying is that, if they needed the money soon, that money shouldn't have been in stocks in the first place.

How does one avoid getting into such a mess? My own answer is, of course, more advice from Michael James. People who have several years' worth of expenses saved up in low-risk (and hence low-return) investments should find their paper losses in stocks inconvenient, but not alarming. Inconvenient, because of reduced liquidity: you don't want to sell stocks while they're cheap, so now you're stuck with them. But not alarming, because it has no impact on your standard of living, since you're not basing your standard of living on your stocks.

I've used an approach (which I christened bottom-up asset allocation) based largely on Michael James's advice. When the market crashed, I was not overly concerned with my deep paper losses; in fact, I bought more stocks. Why would I worry about a drop in the price of a commodity I hadn't planned to sell anyway?

Put money you need for anticipated expenses into stable investments and cash. The rest goes into investments with the highest expected chance of meeting your financial goals, which generally means a diverse basket of stocks. This approach should help you sleep at night while your stocks lose half their value, secure in the knowledge that your paper losses are unlikely ever to be realized.