Chapter 12
Buy-Hold Myth #3: Don't Be the Fool Who Sells at the Bottom
In 2011, the average equity fund investor underperformed the S&P 500 by 7.85 percent. Dalbar, the nation's leading financial services marketing research firm, found that the typical equity mutual fund investor suffered a loss of 5.73 percent, while the S&P 500 gained 2.12 percent. In a March 2012 press release, the Dalbar researchers said, “They (investors) decided to take their losses instead of risking further declines. Unfortunately, as is so often the case, this occurred just before the markets started on a steady trek to recovery.”
Sounds like those investors were fools who sold at the bottom of the market, doesn't it? According to Dalbar, which conducts similar studies each year, this is not unusual behavior. Investors get nervous when the market drops. They may tell themselves to stay the course because they're long-term investors, but they feel the loss of every cent as the market plummets. Eventually, they can't take the anxiety anymore. They panic and sell, often near the bottom of the market. And since history tells us that the market bounces back nicely the first year after a bear market, those investors lose out on the typical rebound. By reacting emotionally, the “fools who sell at the bottom” are shooting themselves in the foot. These investors, indeed, would have done better in the market had they stuck with buy-hold.
Am I saying that “don't be the fool who sells at the bottom” is bad advice? No. I'm saying that you don't want to be the fool who sells in a panic. Big difference.
This particular myth is dangerous because there is some truth to it. Selling at the bottom is obviously a bad idea. But buy-holders use this advice to keep investors from selling at all. They also keep investors in the market with two similar mini-myths: “You don't want to miss the rebound,” and “The rebound is equal to the fall.” They say straight out that anyone who gets out during a bear market is foolish. I think it's their arguments that are foolish.
Mini-Myth: You Don't Want to Miss the Rebound
Those who say “Don't be the fool who sells at the bottom…” often conclude their argument by saying, “After all, you don't want to miss the rebound.”
If you follow a sell strategy that gets you out of bad markets, you could miss a rebound. It's true. But if you're retired, remember that protecting your principal is your number-one job. A defensive strategy, even when it doesn't give you the returns you might have made, protects that principal. One bear market could destroy you, robbing you of an average of 37 percent of your life savings. An enormous loss like that could change your life, especially if you're retired.
Source: Randy Glasbergen.
By sticking with the buy-hold philosophy in order to catch a rebound, you may put your retirement at risk. You have to choose: Would you rather miss a market rebound, or would you rather take shelter and protect your life savings? See Figure 12.1.
Figure 12.1 Don't sell here, because you'll miss the rebound.
Mini-Myth: The Rebound Is Equal to the Fall
“But,” you may say, “Some of these rebounds are fantastic, In fact, I've heard that the rebound is typically equal to the fall. Where's the risk?”
It's true, after the market sinks to its lowest point, the rebound can be very, very big. After the market bottomed in March 2009, it went up almost 90 percent over the next year. But there are risks. To catch that rebound in 2009–2010, you would have had to endure 2008. You would have seen half your money vanish, not knowing if the market would turn around, and you would have needed to stay in the market until the very bottom to capture that wonderful rebound. Emotionally, that's not easy to do. Most people just can't take it. They panic and sell. By sticking with a bear market, you risk falling prey to your emotions.
And even if you have incredible intestinal fortitude, how low do you go? How far do you ride the market down, hoping for a rebound? In 2008, the market dropped 57 percent. Those who panicked and got out of the market at that point sold at the bottom. But during the Great Depression, the market went down 90 percent. Investors who got out back then, when they were down “only” 57 percent, probably thanked their lucky stars they had sold when they did.
There is another substantial risk in riding the market down in order to catch the rebound. Market drops and rebounds are measured in percentage terms. Even if you lost half your money and the market rebounded 50 percent, you wouldn't be back to even. Many people don't understand this concept, including one of the fools in our next story.
The Two Fools of Mayberry R.F.D.
Barney sang, “Oh, I'm gon-na make mon-ey, and it's gon-na be big…” He suddenly stopped and scratched his head. “Hey, Andy, what's a good rhyme for ‘big’?”
Andy leaned back in his chair. “Well, there's ‘pig’…”
“Pig?”
“Or ‘wig,’” said Andy, “But tell me. How are you going to make big money?”
“Well, I've got 100 dollars invested in the market…”
“How about that? I do, too,” said Andy.
“And the market's dropping…”
“That doesn't sound good.”
“No, it's great!” said Barney, “Because I'm going to ride it down and catch the rebound! And it's gonna be big!”
“You know, Barn, I'm going to get my money out of the market.”
“Now, Andy, that's just plain foolish. You'll miss the rebound.”
“I'll take my chances,” said Andy.
A few months later, Barney was singing again. “If I hold on-to my stocks, in time they'll grow big…”
“Never finished that song?” said Andy.
“Still working on it.”
“Still in the market, too? I'm glad I got out. It's down 50 percent.”
“I know,” said Barney. “I only have 50 dollars right now. But I don't want to be the fool who misses the rebound, like some I might know.” He looked sideways at Andy, who didn't seem to notice. “Besides, I'm not worried. The market is gonna come back and its going to be…”
“Big,” said Andy. “Right.”
A year later, Barney burst into the sheriff's office. “I told you, Andy! I told you so!” he said. “The market came back and I made 50 percent!” He cleared his throat. “There's gotta be something that rhymes with ‘percent.’ ”
“Fifty percent,” said Andy. “Sounds good on the face of it.”
“What do you mean, ‘on the face of it?’ I made 50 percent! How much did you make?”
“One percent,” said Andy.
“You should have listened to me. I told you getting out of the market was foolish.”
“Uh, Barn, how much money do you have now?”
“Let's see, I lost 50 percent, so I had just 50 dollars…”
“Right…”
“Then I made 50 percent, so I made…” Barney started to count on his fingers.
“Fifty percent of 50 dollars…”Andy prompted.
“Oh! Twenty-five dollars.”
“So now, you have…”
“Fifty plus 25…I have 75 dollars! Oh.” Barney's face fell. “I have 75 dollars. How much did you say you made?”
“One percent.”
“And you have how much money now?”
“One hundred and one dollars.”
Barney shook his head. “Guess I'm the fool, even after making 50 percent. Beats all, Andy, beats all.”
Which Fool Would You Rather Be?
After reading that story, would you rather be the investor who stayed in a bear market, caught the rebound, and made 50 percent, or the one who made just 1 percent, but protected his principal? Which fool would you rather be?
I wouldn't call Andy a fool in that story. He may have sold, but he didn't sell in a panic. He decided that it was time to protect his investments, and did so without emotion. Most of us, though, don't have the strict discipline it takes to make a dispassionate decision when the market is falling down around our ears. We need to have a sell strategy, to know in advance when we'll sell, and what our trigger point will be. Generals plan ahead so that they don't make rash decisions in the heat of battle. Investors shouldn't make emotional decisions in the thick of a bear market, either.
When you have a strategy, you can make a plan without being driven by your emotions. When we advised our clients to sell in November of 2007, nobody was panicked yet. Things looked bad, but nobody was freaking out. Nobody thought it was the end of the world, but because we had decided in advance what our trigger points were, we got out of the market.
We weren't fools who sold at the bottom. We were practical investors who got out before it got bad because we had a sell strategy. Buy-holders assume investors have no strategy. They assume that investors who sell do so because they can't take the trauma of losing enormous amounts of money. And yes, those who sell in a panic are fools. But those who protect their investments during bad times are just the opposite.