Update 11/9/2016: If you’re reading this in late 2016, you may find this article helpful as well: Donald Trump and Your 401(k): The Effect of a Presidential Election.
“Markets don’t like uncertainty. Markets don’t like surprises.”
-Ashley Banfield, CNN, June 24, 2016
In this morning’s CNN broadcast, the day following Britain’s exit from the European Union, CNN anchor Ashley Banfield stated the well-known axiom that stock markets don’t like the unexpected. This unprecedented current event, the certified vote that cemented the desire of the majority of the United Kingdom’s population to pull out of the European Union, was a shock to the markets. Although the actual retreat from the European group will take place over several years, the stock market reacted with a major sell-off.
Before deciding what, if any, action to take within your 401(k) or other investments, you need to examine several factors.
Why did you create a 401(k)?
You invested in your workplace 401(k) in order to save part of your income today, invest it, so that it will be worth more in retirement. That means if you are saving 5% to 15% of your earnings in a tax deferred 401(k) account, your expectation is that this money will be invested in stock and bond funds and multiply during the upcoming decades. Ultimately, at age 65 (depending on when you retire), you’ll have a nest egg to supplement your Social Security benefits.
Unless you are a year or so from needing the entirety of the money invested within your 401(k) account, you need to take a long term viewpoint.
How investment markets work: the concept of systematic risk
The upcoming weeks will be a crucial time where long term investment returns can be slashed or stabilized. In this brief market history lesson you’ll learn about how Brexit and other market surprises and declines typically play out.
Systematic or market risk is an economic concept that explains a specific type of market volatility. Systematic, market, or undiversifiable risk is a situation when an event causes all market segments to decline in value. This is in contrast with diversifiable or non-systematic risk, which applies specifically to certain companies or market segment declines.
Examples of systematic risk are shown in the chart above with the decline and correlated events highlighted.
- 2008-2009: There was a confluence of several unfortunate economic events; a subprime mortgage meltdown and economic decline leading to a drop in the market.
- 2010: After a slight rebound in the S&P 500 in June 2010, the U.S. reported anemic GDP growth and exceptionally high unemployment levels, and this systematic event caused markets to swoon again.
- 2011: The economic problems in the U.S. expanded to Europe with the European debt crisis leading to another market drop in September of that year.
- Since then, there have been minor drops in the S&P 500, most recently, in February 2016.
Understanding systematic risk is important, because a diversified stock market portfolio can’t protect your investments from systematic risk. By its nature, this type of “systematic risk” causes all sectors of the financial markets to fall, albeit not necessarily equally. Does this mean that it’s time to sell everything in your 401(k) and get out of the stock market? Not exactly. Read on for concrete advice about what to do during market volatility.
The benefits of a diversified 401(k)
Diversification is not dead. In fact, by holding a retirement 401(k) account with a portion of your investments in cash, bond investments, and stocks, if the stock market falls 2-3% in a day, your investment portfolio will decline less.
Assume that you’re a 33-year-old investor with a 401(k) account invested with this asset allocation:
- 80% stock investments (international and U.S.)
- 7% real estate investments
- 13% bond investments
When the stock market falls 3% in a day or 5% in a quarter, it’s likely that your real estate and bond investments will have a positive return. In this scenario, your total 401(k) investments may hold steady or only fall slightly due to the positive returns of the real estate and bond portion of your portfolio.
So, in spite of systematic risk, a diversified portfolio is still important.
Should you sell your assets because of Brexit?
Research has shown definitively that investors who attempt to “play the market” typically underperform the market averages. Dalbar’s 2015, 21st Annual Quantitative Analysis of Investor Behavior found that in 2014, the average equity mutual fund investor underperformed the S&P 500 by a margin of 8.19%. While the S&P 500 returned an annualized 13.69%, the average stock fund investor showed a gain of 5.50%. A similar underperformance by individual investors, when compared with the market averages, held true over 30, 20, 10, 5 and 3 year periods as well.
The cause of this underperformance is frequently cited, both in the Dalbar survey and other investor research as deficiencies in investor behavior. Behavioral finance is filled with examples of investors panicking when markets drop and selling at the bottom, only to gain back confidence after a big run up in stock prices and buy back in after stock market prices rally. In other words, left unchecked, investors can become their own worst investors.
During market volatility investors need to do several things:
- Understand market history and characteristics. Investment markets go up and down.
- Be aware of their own risk tolerance. Regardless of your age, if you simply cannot handle market swings, then you need an investment portfolio more heavily weighted towards less volatile investment classes such as bond funds and cash.
- Pause during market declines and ask yourself when you will need to access your 401(k) or other investment accounts. If the answer is greater than 5 or 10 years away, you’re well served to sit tight. If you need your money earlier, then it shouldn’t be invested in the stock market with cash needed in the short term.
This graph from StockTwits makes an excellent point:
Should you adjust your asset allocation to fewer international stocks and bonds because of Brexit?
You may think it would be a good idea to shift your 401(k) or other investment allocations away from international assets to avoid exposure to the European market while both the UK and the rest of the EU are going through uncertain times. Many of the reasons we’ve outlined above about not impulsively selling your investments in general still apply on the sub-asset class level:
- No crystal ball: You don’t know what’s going to happen specifically to international stocks, just like you don’t know what’s going to happen to the stock market in general, or politics, or the world as a whole!
- Lost potential gains: If you sell now you might avoid some short-term losses in international stocks (and even this isn’t guaranteed), but you’ll also likely miss the eventual rebound because people won’t be able to guess correctly as to exactly when the international stock market will bounce back, which history has shown is almost always the case.
- Where would you reallocate those assets?: It’s not a guarantee that the US stock market will necessarily perform better than the European/international stock market. The markets move in ways that are not always obvious and events in one area can also cause ripple effects in another area.
- You’re investing for the long term: In the long term, you want to have global exposure to the stock market and make sure you’re diversified across regions. You shouldn’t give up that safety net of diversification because of short-term concerns and expose yourself to risk by putting all of your eggs in one basket.
In 2011-2012, at the height of the sovereign debt crisis in Europe, many people thought it was wise to reduce their exposure to international stocks, and because they were unable to accurately predict the timing/duration of the subsequent rebound, they missed out on significant gains (again, see the historical chart above) and lowered the value of their portfolios.
Human Interest: Technology vs. human behavior
One of the reasons Human Interest was created was to help all people, regardless of their level of expertise and experience with concepts like asset allocation, save for their retirements in a strategic way that would have a measurable impact on net worth and quality of life in retirement.
Human Interest has built technology specifically for 401(k)s that mitigates the negative effects (because they typically are exactly that — negative) of human behavior and emotion in stock picking. Here’s a quote from our investment philosophy page, which outlines the research behind the premise of our algorithms. This philosophy is followed all the time, but it’s particularly relevant given the recent Brexit news:
Another common mistake investors make is trying to time the market or adjust their investments in reaction to short-term market news. Numerous academic studies have shown that this behavior can cost an investor between 1.5% and 4.3% per year, because individuals are notoriously bad at predicting the market even if they don’t realize it. By attempting to time the market, investors usually end up buying high, selling low, and trading too frequently, leading them to worse performance than if they had done nothing at all. This phenomenon is so prevalent that it now has a term — the “behavior gap“, coined by author Carl Richards.
In contrast, an investing strategy that reacts to market movements in a mathematical, emotionless manner has been shown by Yale’s Chief Investment Officer, David Swensen, to increase returns by 0.4% per year. This strategy is known as rebalancing, and it involves periodically adjusting your investments to return them back to their pre-set proportions as market movements cause the winners to encompass an ever-larger part of your portfolio. Unlike market timing, this strategy forces you to buy low and sell high, which is why it boosts returns.
Mathematical, emotionless, algorithm-based rebalancing is exactly what Human Interest’s investment tool provides. The automated investing service makes all the investing decisions for you and maintains an optimal strategy even through times that may encourage non-rational decision making. This eliminates the behavior gap and ensures you’ll achieve maximum expected returns.
The final word on market downswings (and upswings)
The best advice on what to do during market declines is: nothing. Continue with your current investment plan. Notice in the “Major World Events Relationship to S&P 500” graph above, that historically, the stock market trends upwards. Does this guarantee that the stock market will always go up? Not exactly. But if 200 years of stock market history is any indicator, it is likely that investment markets will rebound from negative news and price declines. The investors that panic and sell after a drop are realizing their losses and losing the opportunity to participate from the outset in the rebound.
Dollar-cost-averaging into your 401(k) is a sound strategy for building long-term wealth for the future. Realize that short term events and market turmoil are with us to stay and remember to keep any money you need in the next 5 years out of the stock markets. Is your 401(k) holding money you’ll need in the next 5 years? Probably not.