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“Don’t do something, just stand there!” - Jack Bogle
“Be greedy only when others are fearful.” - Warren Buffett
“You make most of your money in a bear market; you just don’t realise it at the time.” - Shelby Cullom Davis
Stocks have been volatile recently, seesawing all over the place but mostly trending down. At the time of writing, the S&P 500 has lost about 9% so far in 2022, and the tech-stock-heavy Nasdaq 100 has lost more than 13%.
You don’t have to be an investment legend to know that it’s rarely wise to be a seller in such environments if you can avoid it. Selling into a downturn violates one of the key tenets of successful investing: selling high. And investors who panic-sell are prone to make emotional decisions that undermine the success of their plans. Even the emotional relief that selling might bring is fleeting, as it’s so often quickly replaced by another nagging worry: Is it time to get back in?
For all of these reasons, the admonition to stay the course in a falling market is often - indeed usually - sound advice. But it also presupposes a few key things that may or may not apply.
The biggie is that it assumes the underlying investment plan and asset allocation are well-thought-out and well-tended.
At least until recently, however, we were living in an era of FOMO, fear of missing out, in which many novice investors barrelled into risky assets with the hopes of overnight riches. It’s a big leap to assume that many of these newbies were operating with an underlying plan or even an appreciation of investing basics like asset allocation, diversification, and the role of time horizon.
And even investors who did have a plan at one point in time may well have found themselves unmoored from it. U.S. stocks have trumped almost everything in sight over the past decade. A portfolio that was 60% U.S. stocks/40% bonds five years ago would be 72% stocks/28% bond today.
Yet getting investors to peel back on a winning asset class in favour of one with a dinky yield (cash and bonds) or underwhelming long-term results (international stocks and also cash and bonds) is an uphill climb. Just as important, many investors’ natural tendency is to do nothing with their portfolios, often for years on end, and that’s especially true when the market is marching steadily upward. They may have heard the advice to rebalance, but they’re busy or not sure how to do it. The path of least resistance beckons.
For all these reasons, I think there are plenty of investors who should, in fact, be lightening up on stocks during the current market downdraft, even though the conventional wisdom is to do nothing.
Here are a few key situations when selling stocks might be warranted right now.
Something has dawned on me as I’ve interacted with older adults over my career (and, gulp, have gotten older myself). Even as our comfort level with risk-taking usually grows as we get our sea legs as investors, our plans’ ability to absorb risk usually diminishes. I think that explains why it’s so tough to get older investors to de-risk their portfolios in the years leading up to and in retirement. They’ve seen this movie. They know stocks usually recover, and their stocks have beaten everything else in their portfolios by a big margin.
And stocks’ current run really dates back to early 2009; the big losses that stocks endured during the GFC have been erased. Is it any wonder that so many older investors are standing pat with equity-heavy portfolios?
Yet even as risk tolerance grows with experience, risk capacity - the ability to absorb big losses in our equity portfolios - declines as we get close to drawing from our portfolios. At that life stage, it’s wise to begin building out positions in cash and bonds as a bulwark.
If a lousy market materialises early in retirement, the investor can 'spend through' the safe stuff versus tapping depreciating equity assets. Heading off sequence-of-return risk helps explain why my bucket portfolios generally hold 10 years’ worth of spending in cash and bonds. It’s also why, in our recent research on in-retirement withdrawal rates, we found that balanced portfolios generally supported higher withdrawal rates than more equity-heavy ones.
New investors have been flooding into the market during the pandemic, thanks to strong gains on stocks and other assets as well as the fact that many individuals have extra time and cash to invest. Research in 2021 from investment firm Charles Schwab found that these newbies have a median age of 35 and their incomes are about $20,000 less than investors who were in the market pre-pandemic. Half of the new investor group - what Schwab calls ‘Generation I’ - are living paycheck to paycheck. A healthy share of the new investor group was expecting to hit big lifetime milestones within the next few years, such as buying a home or having a baby.
Those statistics suggest that some new market entrants are not laser-focused on amassing investments for their retirements in 30 or 40 years. Rather, they may need to tap their portfolios sometime soon to cover an emergency expense, tide them through job loss, or fund some shorter-term, nonretirement goal like a house down payment. If they need to get out of their stock investments at an inopportune time, they could lock in losses.
For a bit of context on why investing in stocks for short-term goals can be so risky, over rolling 10-year periods since 1986, the S&P has posted a loss roughly 18% of the time. The index has posted losses in about 12% of three-year windows over that same stretch. Some of those short-term losses were punishing, especially in one-year windows. The unlucky soul who invested in the S&P 500 in early 2008 and needed to get his money out a year later would have had to settle for a 43% loss, for example.
With U.S. stocks still up more than 10% over the past year, new investors who find themselves with too risky portfolios should feel absolutely no shame in liquidating some of their equity holdings in favour of a portfolio mix that adequately reflects their potential need for liquid assets within the next few years.
The preceding two situations relate to risk capacity, where a too-aggressive portfolio might be at odds with someone’s spending horizon. In other words, their spending goal dates could force a liquidation at an inopportune time (or even worse, force them to change their goals and plans).
But even if an investor has an adequately long time horizon to hold stocks, there’s another issue that can crop up with too-risky portfolios, and that’s capitulation risk. That’s my own term, referring to the chance that the investor could become so nervous during periods of losses that he sells himself out of stocks, thereby turning paper losses into real ones.
Recent market losses are minor relative to the depth and duration of some previous market downturns. The S&P 500 lost half of its value in the bear market that began in March 2000, for example, and that bear market was a grinding one, lasting 31 months. The bear market that ensued during the GFC was quite a bit shorter, just 17 months, but the losses were an even sharper at 56%.
In other words, if the recent market volatility has you spooked, you ain’t seen nothing yet.
While throwing stocks overboard won’t make sense, lightening up on stocks while adding a bit more to bonds and cash just might. In addition, nervous investors can take a closer look at the complexion of their equity portfolios, making sure they have a balance between value and growth stocks and hold some international as well as domestic stocks.
Alternatively, investors might use their response to the recent market action as an impetus to delegate their portfolio management to a professional adviser. Doing so can help reduce the worry, ensure a situation-appropriate asset allocation, and help protect the investor from his or her own worst impulses to trade at inopportune times.
Granted, this is a niche case. But for investors who recently purchased securities in their taxable accounts that have subsequently declined, selling to harvest a tax loss may be a way to find a silver lining (subject to complying with relevant legislation). Those losses may be used to offset capital gains.
Be sure to consider the 45-day holding period rule in Australia if you’d like to maintain ongoing exposure to an asset. Also in Australia, where a transaction is entered into with the dominant purpose to access a tax benefit, the Tax Act provides the Tax Commissioner with powers to cancel the transaction and make a compensating adjustment.
First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.
Christine Benz is Morningstar’s Director of Personal Finance. Analysis as at 02 February 2022. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.