Before the crash: What investors do now could come back to haunt them
No one knows when the bull market will become a bear, so focus on what you can control
Preparing for the next stock market meltdown seems like a no-brainer. We know it’s coming. Why not treat it the same as we would a flood or a wildfire – i.e. get the hell out of the way?
Anyone who has lived through a financial disaster knows how scary they can be. In 2020, the S&P/TSX Composite Index dropped by almost 40 per cent in a month. Nearly half of the index’s value was wiped out in the back half of 2008.
An everyday investor could easily have seen tens of thousands of hard-earned dollars vaporize.
Today, dark forces are stirring again – a mass repricing in the bond market, a global energy shock now in its eighth month, and an artificial intelligence bubble.
Your inner alarmist may be telling you to run away. Plenty of voices in financial commentary are saying the same.
Tim Shufelt: Don’t let the scary stuff chase you out of the stock market
But it’s a trap. Consider for a moment that two years ago, the chatter in financial markets was much like it is today: valuations are too high and investors are too exuberant. If you let the permabears chase you out of the stock market then, you missed out on a historic run in stocks. In the past two years alone, the TSX has gained 47 per cent.
While there are steps an investor can take today to cushion the blow of a selloff, a significant retreat from the stock market should not beone of them. An investor’s risk exposure, which is a function of things like age, income, and life goals, shouldn’t be cut just because the stock market is running hot.
Peter Lynch, the famous fund manager, said it best: “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
To state the obvious, nobody has the slightest idea when this glorious run in stocks will end, giving way to the next bear market. Maybe the turning point already happened a couple of weeks ago, when U.S. tech stocks peaked and started to dip. Maybe it won’t happen until 2031.
If you bet on the former, you miss out on the latter.
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A recent analysis by strategist Joseph DeSipio for research firm Alpha Architect illustrates the dilemma from the perspective of institutional investors.
Hedging against rare, extreme market events – what is known as “tail-risk investing” – can be expensive. The longer a bull market endures, the more the costs of protection add up. The hedged investor steadily underperforms fully invested peers and the strategy becomes ever harder to defend.
“The central failure of tail-risk protection is usually not the crash. It is the years before the crash,” Mr. DeSipio said.
Most retail investors aren’t dabbling in futures and options contracts. But they face a similar problem. There is an opportunity cost to lightening up on the stock market. Let’s say an investor, concerned with valuations and bubbles, takes a chunk of their portfolio out of the market and puts it in cash.
For starters, that money misses out on whatever upside remains in the stock market in the months and years ahead. A bull market’s final innings are often its most lucrative, when you tend to see “melt-ups.” The TSX shot up by 63 per cent in the final year of the dot-com bubble, before it all fell apart.
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The over-cautious investor is then confronted by a second dilemma – when to put their excess cash back into the market. They may plan on buying when there’s blood in the streets. But market bottoms don’t announce themselves. And investor sentiment is typically still pretty rotten in those moments. It’s easy to miss the turning point while waiting for further downside.
Still, there are a couple of tweaks investors ought to make. Rebalance, for one. A portfolio with a 70-30 split between stocks and bonds in 2020 would have drifted to about an 84-per-cent stock weighting today, Ritholtz Wealth Management founder Barry Ritholtz pointed out in a blog post last week. You may have too much exposure to stocks without really knowing it.
It may also be a good idea to check your concentration. The run-up in AI stocks has lifted the tech sector’s weighting to near-record highs in the U.S. stock market. But keep in mind the TSX is just as concentrated, by some measures. The 10 largest Canadian stocks account for a 39 per cent share of the index – not far off the S&P 500.
Other than that, doing nothing is a pretty good move. This is one instance when overpreparing for a disaster can backfire badly.