We all know what’s good about stocks. Stocks provide great long-term returns.
Is there anything bad about stocks?
There is. The bad thing about stocks is the price volatility. You never know where you stand. One day your net worth is $100,000. If the money is in stocks, the number a year from today might be $130,000 or $70,000. You just don’t know. That’s scary.
The thing that determines whether you will become a successful long-term investor or not is how you deal with the fear caused by price volatility. The most common way of dealing with it is through denial. No one literally denies that prices are volatile. But many block this reality out of their minds. They would as soon draw up a will as develop a strategy to deal with price volatility. They act as if they believe that dealing with the problem will cause bad things to happen to them.
There have been three times in the past when stock prices have been where they are today. The average price drop for those three occasions was 67 percent. What are you going to do if the value of your portfolio is cut by two-thirds? Do you have a plan?
Lots of people say “buy-and-hold is my plan.” I don’t think that works. It’s too pat. Your life is going to change in dramatic way if the value of your portfolio is cut by two-thirds; lose that high a percentage of your accumulated wealth of a lifetime and there are going to be fewer options left open to you in all areas of life endeavor. You really are just not going to let that affect you? Are you sure?
Remember, if things go this time as they have gone all the other times, most other middle-class investors will be abandoning stocks when prices drop. It’s easy to practice buy-and-hold when everyone is saying it’s a good idea. It’s not easy when everyone is saying that the best thing is to abandon stocks. That will be what most people will want to hear when most people are abandoning stocks, and most stock “experts” have made it a longstanding practice to tailor their advice to meet the current desires of most of their listeners.
I don’t think you are going to hold if prices drop by 67 percent or by anything close to it. I don’t say that because I think you are weak. I say that because I don’t think any reasonable person would hold onto an asset that had lost 67 percent of its value. People don’t do things like that, and for a perfectly good reason. Doing things like that is nuts. Who the heck can afford to lose 67 percent of his or her life savings? Who the heck can afford to take that sort of hit and not take some kind of action?
Buy-and-hold does not work. It is not realistic.
At least that’s so of the version of buy-and-hold that has been widely promoted for 25 years now
I propose a new approach to buy-and-hold, one with all of the advantages of the now popular approach but without the terrible failing that it cannot work in the real world.
The problem with the conventional approach to buy-and-hold is that it ignores the way the stock market performs. Stocks are not really one asset class. They are two, two, two asset classes in one.
When stock prices reach extreme highs, stocks are a dangerous asset class. There are always huge wipeouts of middle-class wealth when stock prices reach extreme highs. There are no exceptions in the historical record.
When stock prices are normal or low, there’s not much risk. Stock prices might go down a bit from moderate or low prices. But probably not too much. And, if they do go down a good bit, the price drop is not likely to remain in place for long. At least that’s always been the case in the past. Again, there are no exceptions in the historical record.
Here’s my plan for escaping the worst effects of stock-market volatility: Lower your stock allocation when prices reach extreme levels (like those that apply today). That way you are heavily in stocks most of the time and get to enjoy the wonderful long-term returns generally associated with stocks. But you miss out on those huge price drops characteristic only of stock markets for which prices have been permitted to get out of control.
It makes sense to me.
What doesn’t make sense to me is the negative reaction I sometimes hear to this idea. It is my view that that negative reaction is a signal of defensiveness. It is because investors trying to pull off the conventional approach to buy-and-hold don’t really deep in their hearts believe that it can work that it makes them anxious to hear about other strategies, strategies that could help them if they could chill out a bit and think things through without too much emotion getting in the way.
Do I believe in buy-and-hold? Sure. Stocks rarely get to the sorts of price levels that apply today. So it is going to be a rare event when you are going to need to lower your stock allocation to protect yourself from monster price drops. It makes all the sense in the world to hold your stocks through the moderate ups and downs that apply for investors who buy their stocks at reasonable price levels. When the monster price crashs become a live possibility (probability? certainty?), however, I think it makes all the sense in the world to take a little something off the table until our fellow investors come to their senses and pull stocks back to more reasonable price levels.
It’s just an idea, you know? I think it’s a good one. If you don’t, that’s of course fine. We can of course still be friends. I ask that you not get mad at me because I put the idea forward and that you give the idea some thought if your initial impression is that it might make sense.
Today’s Passion: The Investor’s Scenario Surfer lets you test how you would respond to various return patterns without requiring you to put actual money at stake.