Sunday, 17 January 2016

The Danger of getting out of stocks during the Bear Market.

Reactions to turbulent and bear markets vary by investor. 

Some are unfazed by large drops in stock prices, and even view them as buying opportunities (“Buffett-like investors”). 

Others curtail their stock holdings when the market incurs a steep drop, but don’t completely pull out of stocks (“nervous investors”). 

There also are many who get out of stocks completely during a bear market (“panic investors”) out of fear of incurring further losses.

Given wide variances in how each investor reacts to bear markets— the aggregate data does imply, however, that Buffett-like investors are likely a comparatively small group. More people probably fall into the nervous and panic investor groups. This is not surprising, given the human inclination to be risk-averse. 

As Daniel Kahneman and Amos Tversky demonstrated with “prospect theory,” we feel the pain of losses much more than we derive pleasure from gains. 

Compounding matters, we humans commonly engage in hyperbolic discounting, which means we place greater value on rewards received sooner rather than later. 

When the market falls and stocks are sold, we see the immediate value of avoiding further losses. 

What isn’t considered are the potential future gains forfeited by not continuing to stick with stocks or, better yet, by rebalancing and allocating more money into stocks.

Rebalancing: A Better Method

If panicking is a big problem, a strategy that helps an investor to maintain a constant exposure to stocks should logically produce benefits. While some may view the best advice as simply being “don’t panic and stay allocated to stocks,” such guidance only works well for Buffett-like investors. All other investors need a strategy that gives them a sense of control. This is where rebalancing comes into play.
Rebalancing is the process of adjusting your portfolio back to your targeted allocation. For example, say your allocation calls for a 70% allocation to stocks and a 30% allocation to bonds. After a bad year for equities, your portfolio’s allocation changes to 60% stocks and 40% bonds. Rebalancing would prompt you to shift 10% of portfolio dollars out your bond holdings and into stocks, bringing your portfolio back in line with your targets.
Rebalancing is a buy low/sell high strategy—the opposite of what many investors actually do. It prompts you to buy assets after they have fallen in price. This may sound counterintuitive and may even be difficult to do the first time you try to employ it. Yet its bear market benefits may convince you of its value. Rebalancing lessens the blow of bear markets, making it easier to stick with stocks. In addition, rebalancing restores a sense of control. Rather than being left wondering what the best decision is for your portfolio based on what the pundits are saying about market direction, you have a strategy that prompts you to act and gives direction on how to do it.

No comments: