When Markets Crash, Doing Nothing May Not Be The Best Advice by Nate Eads, CFP®

When Markets Crash, Doing Nothing May Not Be The Best Advice by Nate Eads, CFP®

When markets are crashing, many investor’s reaction is to start selling so they don’t have to feel the pain of seeing their account values go down further.  As most experts will tell you, trying to time the markets by selling after they have dropped, even if you anticipate further declines, and then trying to get back in at some point when things “look” better rarely, if ever, works.  The advice given by most professionals is to not look at your statements and wait for things to improve.  In other words, do nothing.  Unfortunately, sitting back and doing nothing can be difficult to do and may not be the best approach after all.

Let’s assume a $1,000,000 portfolio with a mix of 10% cash ($100K), 30% bonds ($300K), and 60% in stocks ($600K).  During a bear market, it is not unusual for stocks to go down by 30% - 35%.  Let’s assume during this drop in stocks that the bond portion goes up 2% and cash stays even.  For simplicity’s sake, lets also assume this occurs over a year’s time.  After the bear market, the portfolio is valued as follows:

The overall portfolio is down a little over 20%.  Now let’s assume that the market rebounds over the next year with a 25% return in stocks (not that unusual after a significant decline), bonds go down by 5%, and cash stays the same.  Assuming no changes were made to the portfolio, the value after the rebound is as follows:

One year later

Year 2 annual return of 10.3%

Now let’s assume that instead of just riding out the market and not making any changes, the portfolio is rebalanced after the bear market back to the original portfolio mix of 10% cash, 30% bonds, and 60% stocks.  If this action is taken the portfolio mix will be as follows:

Rebalance to initial weightings

Assuming the same returns as above when the market rebounds, the rebalanced portfolio values after year 2 are as follows:

One year after rebalance

Year 2 annual return of 13.5%

By being proactive and rebalancing the portfolio when opportunities present themselves, returns can be significantly improved over time.  In this example, the return in year 2 for the rebalanced portfolio saw a 30% improvement compared no action being taken.   

Of course, this is a simplified example and markets don’t work this neatly.  It is almost a certainty that the timing of rebalancing the portfolio will not coincide with the market bottom.  However, if stocks continue to drop, more rebalancing opportunities will be available.  There may also be rebalancing opportunities between the different types of stock investments (international stocks, real estate, small capitalization stocks, etc.) and even some within different bond investments (government bonds, high yield bonds, etc.). 

For investors that are living off their portfolio, there should be enough cash either in the portfolio or held separately to cover one to two years’ worth of expected withdrawals, with several more years’ worth in lower-risk investments, typically bonds.  This cushion not only allows for investors to ride out the storm in stocks, but to take advantage of the sales and improve their long-term performance. 

As Warren Buffet stated in Berkshire Hathaway’s 2016 annual report: “Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold.”  While there is no way to know if stocks will continue to fall as we fight this invisible enemy, we will eventually persevere and the economy and markets will recover - just as they always have.  Bear markets offer opportunities and prices that may never be seen again.  The disciplined and savvy investor will not only avoid abandoning their strategy at an inopportune time but will also look to take advantage of the opportunities before them.