Pray for Rain

February 18, 2014

I wish the market kept falling. 

That may seem like a strange – even masochistic – wish. Our portfolios go up and down with the market and always have. As investment advisors that charge a flat fee for portfolios we manage directly (you can follow the online portfolios for free by signing up for our alerts), we earn more money when stocks go up. We don’t run some high-fee hedge fund that has huge short positions, or sell negative market predictions and research. 

Our financial fate is similar to that of most investors saving for retirement in IRAs, 401(k)s, and other accounts, at least partially with stock funds and ETFs. It's tied to market success, not failure. 

You can see this direct relationship illustrated in the chart below. As stocks go up or down, our Powerfund Portfolios go up or down. In this snapshot from our “Stats” page, we've plotted long-term performance for each model portfolio since inception. 

The blue line represents our aggressive portfolio, the green line our conservative portfolio, and the orange line the S&P 500 (with dividends). 

Some  prefer to show market returns as index changes without dividends in order to set the bar low for comparisons, but we don’t roll that way. Click here for more disclosure and info on how we  calculate portfolio performance.

The recent stock slide that began in late January took the market down just over 5%. The markets have mostly recovered from that brief dip, with the exception of emerging markets, which have been heading largely down since April 2011.

Who doesn’t love money? Who doesn’t hate losing it? Individual investors returned to the stock market after years of strong returns following the 2007-09 collapse. They seemed pretty eager to jump out of the pool during this most recent drop, taking tens of billions out of stock funds, which turned out to be a bad idea, considering the market’s quick recovery. These investor outflows are actually the main positive we see for stocks right now. Economic and market fundamentals aren’t as enticing.

So does some part of us sort of root for a market pullback? Here are some reasons nearly any investor (not just Bobby McFerrin) should stop worrying and even be happy about a drop in stocks:

1. If you're not 100% in stocks all the time, stock slides are the secret to performing well relative to the stock market – by not losing as much on the way down.

You can see this phenomena in play in our conservative portfolio (see green line on chart,) which has always been significantly allocated to bonds (you can view its compete trading history back to early 2002,) but is still ahead of the S&P 500 even after this current strong period for stocks, partially because it fell so much less than the market did during 2002-2003 and 2008-2009. 

The S&P 500’s performance will eventually "catch up" to the conservative portfolio if it continues to rise, especially now that today's bonds and cash yield so little compared to most of the portfolio’s history, but only if we avoid another 25%-50% stock drop in the future. 

In the event of such a drop, even our conservative portfolio's since-inception return should remain well above the stock market, even when we have a 20-year performance history. Of course, past performance is no guarantee of future returns.

2. You're not done saving. If you’re in retirement, investing aggressively and drawing down on your stocks each year, or if you need most of your money for a large purchase, a significant stock drop could definitely be bad news. But if you're not done saving, or at least nowhere close to the age of withdrawals, who cares? Better yet, you'll probably make more money in the long run.

First of all, let’s assume that where the stock market's going to be in 25 years has very little to do with this year’s up and down swings. If you know the market's going to be higher than today at some date in the future and the market slides, say, even 50% tomorrow, all your 401(K) contributions and the like are going to be invested at prices that will earn you more money, both in dividends and capital appreciation. 

Unless you lose your job or we experience a multi-year depression due to the severe stock market slide, there are plenty of positives and few negatives to your stock market savings. The painful flipside is a sky-high market throughout most of your big savings years followed by a slide near the end.

3. Taxes. For those saving outside of tax-deferred accounts, low stock prices mean minimal taxes to pay along the way and deferring more gains to the future, when you'll likely be in a lower tax bracket. 

While you're saving the most, you're probably in the highest tax bracket of your life. Who wants to realize taxable gains on top of this? This unfortunate side of a strong market reared its head in 2013, when fund year-end capital gains distributions hit multi-year highs as fund managers passed gains on to shareholders.

Unless you own all your stocks directly, you're also paying flat fees to the funds in your 401(k)s, and to managers like us that manage your money. While our fees are low compared to most advisors and brokers, and most of the funds we use have far-below-average annual fees, all such fees are based on total assets under management, which means you pay less along the way if the market is lower. Your ideal market is one that skids down to single digit P/Es for years before running up right before retirement. You’ll save a bundle in fees; I will not be flying with NetJets. 

4. If you like to buy on weakness, a market slide can only magnify your returns. Even if you just rebalance frequently or own a balanced fund that automatically stays balanced, you'll be buying stocks on the way down and selling them on the way up. This extra boost to returns wouldn't exist if the market just crept up steadily.

The only real negatives to a stock market slide from an investor point of view is a) if the market slide is so severe as to damage the economy in a way that hurts you beyond your portfolio; b) you need your money around the time of the crash; or: c) you buy high and sell low due to sheer panic.

Market volatility – and volatile individual investors in general – often turn what should be a boon to investors into a boondoggle. Wild swings lead to poor entry and exit points by investors. This is why the most volatile funds often create the least wealth over long periods of time, even if the long-term returns are better than the lower price swing funds. Fund investors weren’t loading up on stock funds in 2009, or even 2011, and certainly not way back in in 2002 . They were selling. Then, somewhere in the last year or so, with the market up well over 100%, they started buying again. 

Stick to a permanent balanced allocation (you don’t need our online portfolios or some high-fee broker or advisor for that) or use pullbacks to increase your stock allocation which is one of our goals. Anything else is going to hurt your returns.