about 3 years ago • 4 mins
When the fear of missing out outweighs the fear of making losses, markets may well be entering the euphoric stage that so often heralds an impending crash.
But even if investment prices are bubbly, no one can say with certainty just when they’ll fall flat – or how much higher markets may grind before that happens. As an investor, you’re essentially left with three options.
“I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and direction of the various phases is not.”
Perfectly timing the markets is notoriously tricky, if not impossible. It’s therefore important to understand the tradeoffs you’re making when choosing a strategy to combat the crash. I’ll break these down across all three potential scenarios.
1️⃣ Exit early
If the eventual market dip turns out to be significant, it may be a good idea to get out now – even if that means missing out on some gains in the interim. As the chart below shows, an investor in the US S&P 500 index with a three-year horizon would have been best off exiting in October 1998 or October 2005 – two full years before US stocks subsequently topped. A missed gain is better than a realized loss.
Exiting early doesn’t necessarily involve cashing everything in at once. You could instead gradually reduce your portfolio’s exposure to stocks. This option gives you both cash on hand for when markets begin to recover and protection against the asymmetric impact of losses (remember, you need a 100% gain to offset a 50% loss: if you’ve got $100 and lose 50% you’ve got $50 left, but to get back to $100 you’ll need to increase that $50 by 100%).
Avoiding the burn of heavy losses gives you both psychological and capital advantages when it comes to profiting from stocks’ post-crash rebound. What makes this strategy difficult to put into practice, however, is the self-belief (and self-restraint) it takes to sit things out if markets continue to rise.
2️⃣ Exit late
An alternative approach is to ride markets past their peak and exit after the crash has already started. You could time that withdrawal using a technical indicator such as 12-month price momentum (which measures an investment’s performance over the preceding 12 months).
As shown below, paying attention to this signal would have worked out incredibly well during the crashes of 2000-02 and 2008. And this option has the obvious advantage of allowing you to keep making money so long as things keep going up. Markets, after all, can remain irrational longer than you can remain solvent.
This strategy has two big drawbacks, however. First, it won’t protect you against a short, sharp drop, as in March last year. Looking at past returns means you’ll always be late to exit – and since markets take the stairs up and the elevator down, you might find yourself closer to the lobby than you’d like.
The second downside is that the success of this approach relies on the crash being large and long-lasting, like in 2000 or 2008. If nimbler investors buy the dip and markets recover before your indicators turn positive again (as in March 2020), this strategy could cost you.
3️⃣ Do nothing
Markets have always risen in the long term – and since timing is hard, simply buying and forgetting may not be the worst idea. Of course, a large crash could leave you looking at years or even decades before your returns turn positive. But on the other hand, inaction may suit you if you think that 1) a crash won’t necessarily happen, or 2) any correction will be small.
“Buy and hold” sounds easy in theory, although it may be harder in practice. You’ll need to fight the urges to invest more when prices are near the top and to cut your losses when markets are near the bottom.
Which option’s right for you obviously depends on your objectives (time horizon, loss tolerance), your behavioural biases (can you handle FOMO?), and your overall market outlook (how unsustainable is the current environment – and could this time really be different?).
Importantly, these three strategies aren’t mutually exclusive. In fact, the best approach of all may be to combine them. You could, for example, keep 50% of your pot invested no matter what, take 25% off the table now, and use 12-month momentum (or another indicator) to tell you when to yank the remaining 25%.
The biggest risk to your long-term investing performance is neither coronavirus nor central bank policy: it’s yourself. Without a concrete plan, your emotions will push you into making the wrong decisions at the worst times – like increasing your risk when euphoria and markets are at their highest and exiting when sentiment and markets are ripest for revival.
Ask anyone who invested in GameStop how easy it was to take profit. Putting a plan in place instead – and respecting it – will in all likelihood make a much bigger contribution to your investing success than picking the hottest stock of the month. Stay safe out there, Finimizers...
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.