Why not sell out and get back in when things are calmer?  That is the question many investors are asking as the Coronavirus-provoked market volatility continues.  At first glance, it may seem obvious why that is a bad idea.  The wisdom of holding on and not selling stocks into a down market is common knowledge.  The reason being that investors will not know when to get back in and, as a result, will miss out when the market bottoms and begins an (often strong) recovery.

But there is a more subtle argument worth considering.

What if an investor is aware of and willing to give up the potential gains afforded to those who hold on in rough markets?  What is wrong with an investor saying, “I know I may miss some of the gains off the bottom and I’m OK with that”.

Actually, nothing…but…

It is worth considering what the consequences are for an equity investor that limits exposure to the market through timing.  Equity investors that give into panic selling are likely to miss significant daily gains even in the midst of severe down markets.  Missing just a remarkably small number of the best trading days permanently impairs long-term realized equity returns.  Or stated another way, selling equities into down markets converts potentially higher equity returns into expected returns similar to those of high-quality bonds.

It turns out that missing just the 15 best trading days over 29 years (1990 – 2018) turned the realized return of large U.S. stock investing (as measured by the S&P 500 index) into the equivalent of a 100% investment in a AA-rated corporate bond portfolio.

Table 1: S&P 500 (ex. 15 best trading days) vs AA-Rated Bonds (1/1/90 – 12/31/18)

IndexAnnualized Return
S&P 500 (excluding 15 best trading days) 5.79%
Bloomberg/Barclays Credit Bond Index AA 5.72%
Source: Dimensional

 

During the current Coronavirus crisis period (February 20th 2020 through March 20th 2020), a period during which the S&P 500 is down over 30%, daily gains of 9.3%, 6.0%, 4.9%, 4.6%, 4.2% have been realized by equity investors who stayed in the market.  It is reasonable to assume that these days will be among the best trading days over the next 29 years.

A low volatility portfolio that offers modest returns is a tradeoff that is easily attainable without the stress of owning stocks during a market meltdown.  That tradeoff is available by investing in a high-quality bond portfolio and there is nothing wrong with that strategy if that is the risk-return experience someone desires.

This raises an interesting question.  Rather than going through the process of equity investing and selling into down markets to realize bond returns, why not eschew equities altogether and invest solely in a portfolio of high-quality bonds?  As an investor, the choice is yours: are you truly seeking higher potential stock returns (with all the emotional and economic pain that will likely entail) or the smoother experience but likely lower returns of high-quality bonds?