At this point, it is both trite and painful to revisit the many challenges we faced as a nation in 2020. The virus pandemic, national quarantine period, heightened political/ social tensions and a divisive presidential election created a palpable sense of anxiety in our society. A significant downturn in the stock market in 1Q 2020 accompanied the arrival of the COVID-19 pandemic and added to our collective sense of disruption and uncertainty.
While the experiences referenced above were unquestionably challenging, valuable behavioral finance lessons can be gleaned from the emotional rubble that was 2020. To understand these lessons, it is important that we first establish the facts related to the performance of the capital markets in 2020:
S&P 500 Index Data:
|COVID Crash (February 19, 2020 – March 23, 2020):
|Election (November 2, 2020 – November 16, 2020):
Barclay’s US Aggregate Bond Index Data:
Lesson #1: Diversification WORKED in 2020:
Most investors are aware of the benefits of maintaining a diversified portfolio of investments to avoid the volatility that is associated with concentrating wealth in any one investment. Portfolios can (and in most instances should) be diversified among assets (stocks, bonds, real estate, etc…), asset classes (large capitalization stocks, small capitalization stocks, international bonds, etc…) and investment styles (growth, value, blend, etc…).
Diversification helps to prevent a significant downturn in one particular asset, asset class or investment style from damaging the performance of an entire portfolio of investments. An example of diversification commonly employed by retirees involves allocating 60% of the assets in a portfolio to stocks (in this example represented by the S&P 500 Index) and allocating 40% to bonds (in this example represented by the Barclay’s US Aggregate Bond Index).
The stock market experienced a precipitous decline in 1Q 2020. The value of the S&P 500 Index fell -33.9% from February 19, 2020 through March 23, 2020. To put the steepness of the decline that was experienced in 1Q 2020 in perspective – please recall that the decline experienced during the Great Recession in 2008 was -36.7%, but it took a YEAR to elapse. The decline that was experienced during the COVID-19 Crash in 1Q 2020 occurred in approximately one MONTH.
By the time the dust had settled at the end of 1Q 2020 (and after a surprising market rebound that began on March 24, 2020) – the stock market had declined by -20.0% in the first three months of the year.
While that decline is significant – employing a diversified portfolio in 1Q 2020 would have significantly mitigated the portfolio’s volatility. The bond market enjoyed POSITIVE performance in 1Q 2020 (3.1% growth) while the stock market was reeling. Allocating 40% of the assets in a portfolio to the bond market would have generated a weighted average return of -10.8% in 1Q 2020. Now – no one is rooting for a quarterly loss of almost -11.0%; however, that sure beats a loss of -20.0%.
Lesson # 2: Inaction Proved to Be the Best Action in 2020
A common refrain in the financial advisory industry is the importance of TIME IN the markets as opposed to TIMING the markets. Investors are often intent on attempting to determine the most opportune date on which to purchase an investment to generate growth or to sell an investment to avoid a potential loss. Market timing strategies are rarely successful and when they are – it is difficult to determine if the success that was enjoyed was a result of skillful market timing or good luck.
Maintaining a prudent long-term investment philosophy is ESPECIALLY advisable during periods of significant uncertainty and volatility (such as 2020). It would be unfair to fault an investor for succumbing to emotion-based decision-making during the onset of the virus pandemic and subsequent disruption in the stock market that was experienced in 1Q 2020. That being said – the value of partnering with a trusted professional advisor cannot be overstated during such periods of downward volatility.
The temptation to exit the stock market during market turmoil is understandable. Some investors moved to an ultra-conservative stance during the COVID-19 Crash to avoid additional declines. Those investors not only realized the losses that were experienced during the downturn – they may also have missed out on significant rebounds that were experienced in the second, third and fourth quarters of 2020 (as referenced in the performance data above).
Finally, even the most fortunate attempt at market timing may not be significantly fruitful. Please examine the following data:
|Investing $1,000 per year from 1965 – 1995:
Perfect timing = investing at the lowest point each year
Worst timing = investing at the highest point each year
No timing = investing at the beginning of every year
|Perfect timing return = 11.7%
Worst timing return = 10.6%
No timing return = 11.0%
The data tells a compelling story. While the best outcome (11.7%) is (of course) achieved by timing the market exactly right every year for THIRTY YEARS, the outperformance is not significantly greater than the strategies that involve the WORST timing (10.6%) or no timing strategy at all (11.0%). Furthermore, the ability to achieve perfect timing in any ONE year is difficult and achieving perfect timing every year for thirty years is daunting. And that says nothing of the (apparently unnecessary) stress and anxiety that accompanies an attempt at market timing.
Lesson #3: A Contentious Presidential Election Does Not Necessarily Portend a Stock Market Decline
Please note that I intend to avoid all discussion of politics and political ideology in this lesson. That being said – I, for one, am thankful that last year’s election cycle has concluded. The political ads have ceased, signs in the front yards have been taken down and the incessant election coverage by the media outlets has subsided.
Furthermore, the anxiety that my clients experienced during the election cycle has (somewhat) dissipated. I don’t think the readers of this blog will be surprised when I state that I shared conversations with MANY clients and retirement plan participants who intended to alter their long-term investment strategies in 4Q 2020 because of the presidential election. These individuals are of varying political affiliations and demographic associations; however, they all shared a similar attribute: fear of an impending crisis during or immediately following the presidential election. The turmoil that followed the election validated their fears (to some extent); however, the stock market did not plummet and the decision to shift to an ultra-conservative stance during 4Q 2020 proved to be unjustified.
The stock market surged by 10.9% in the TWO WEEKS immediately following the 2020 U. S. presidential election. The surge was not necessarily directly correlated to the election (Pfizer announced a resoundingly successful vaccine trial on November 9, 2020 and the stock market reacted very favorably to the news). Unfortunately, many investors did not participate in the rally because their fears about a short-term event (the election) informed their decisions about their long-term objectives (for instance, retirement).
A similar behavior pattern occurred during the presidential election cycle in 2016. Investors were fearful of a market disruption on or around Election Day. Additional anxiety ensued after Donald Trump’s surprise upset of Hillary Clinton. Many investors took evasive action and exited the stock market following the 2016 election and the market responded with a significant rally (+21.8%) in 2017.
Please note that the lessons referenced above do not assert that negative events will never occur or should not be considered in your long-term financial plans. On the contrary: these lessons encourage us to ASSUME that disruptions will not only occur but are virtually inevitable. How we react (or in most instances DON’T react) to unknowable and uncontrollable experiences and events is a primary contributor to success of a financial plan.
That is not to say that you cannot exert any influence on the achievement of your financial planning objectives. Try to control the controllable elements of your plan:
- Establish healthy behavioral finance habits like operating a functioning budget, avoiding excessive debt and actively participating in the financial planning process.
- Partner with a professional advisor to help you navigate decisions that would otherwise be governed by emotions and reactionism.
- Avoid allowing the media (especially social media) to inform your decision-making process.
- Establish a written financial plan to add structure to your objectives.
- Carefully examine the costs, risks and taxation associated with the portfolio of investments that you rely upon to achieve your objectives.
2020 ambushed us and most people are glad to have turned the calendar to 2021. Let us at least benefit from the lessons that were learned from last year’s struggles.
If you have questions or want to speak to an advisor please contact us at email@example.com or 614-717-9705.