This Too will Pass

Woot! This is every investor’s idea of fun. Yesterday marked the fourth anniversary of the stock market’s current bull run. Meaning that the the stock market hit bottom on March 9, 2009, and has been trending upward since. The S&P 500, a broad index of big stocks, closed at 676.52 at the market bottom four years ago. It closed at 1556.22 today. The Dow Jones Industrial Average closed at 6,547.03 back on March 9, 2009. It closed at 14,447.29 yesterday. That’s a 131% gain for the S&P, and a 120% gain for the Dow. Spread over the four years, that gain is equivalent to a 23.35% annual return for the S&P, and a 21.88% annual return for the Dow. And the closing numbers for both of those indices are an all-time record. I’ll say it again: Woot!

Now before the celebration gets out of hand, I should remind you of a couple of things. First, this too will pass. The market will not head up forever. Somehow people have a hard time not believing that whatever is happening in the market right now will continue ad infinitum. When markets are tanking, advisors have the difficult job of convincing frightened investors that the collapse isn’t permanent; that the storm will break one day; that there is nothing to fear but fear itself; that their goals and dreams will not be well-served by abandoning ship when the seas get rough. Bear markets have come and gone before, we tell them, and this too shall pass.

Oddly enough, we have to give the same speech when unreasoning fear is replaced by irrational exuberance in a long-running bull market. Suddenly people who have been timid and principal-obsessed want to go all-in on small company stocks. They throw caution to the winds as they start imagining what their portfolios will look like after fifteen consecutive years of 20% gains. While I hate to be a wet blanket, I must caution those people that they have better odds of being struck by lightning than they do of seeing this run continue at this pace for years to come. Year over year growth of 20% or more has never been the norm, and there is no reason to think it is about to become the norm. The uptrend will invariably turn down again. The party is never permanent. This too will pass. If you can’t take the inevitable heat, now’s a good time to get out of the kitchen.

But I hope that’s not you. Because over long periods of time, the up days have always outnumbered the down days. The history of the stock market is of a long upward march regularly punctuated by catastrophic (albeit temporary) declines. The spoils belong to those who can stay disciplined through the ups and downs.

This brings up the second thing we need to discuss. Most investors don’t achieve anything near the index returns in their own portfolio. Why? Because when markets are tanking, they start to fear the decline will be permanent and bail out. That’s called selling low. And when the market turns around, they are slow to believe it, until record highs and euphoria convince them to buy back in. That’s buying high. You’re supposed to buy low and sell high. It just works better that way. But as one sage observed, the stock market is the only market where customers are unwilling to buy during a big sale. They want to wait until prices go back up before buying. If you doubt this, consider the fact that over the last several years, stock mutual funds have been suffering net outflows. That means more investor money was leaving the funds than was coming in. This finally changed about a month ago, as the markets were approaching new record highs. Consistently buying high and selling low will not make you prosperous.

How can you avoid the temptation to buy high and sell low? When you make your next IRA contribution, and when you have the opportunity to change your 401(k) allocation, consider this strategy: Put the most money into the asset class that performed the worst over the last twelve months. Put the smallest portion of your investment into the category that performed the best. You’ll be buying more of what’s on sale, and less of what’s marked up. You should consider reallocating the entire account balance (not just the new contribution) along those lines. You’ll be selling high (the stuff that appreciated the most) and buying low (the parts of your portfolio that are cheapest). It won’t feel right. It never does. But it’s smart strategy if followed consistently. So sell the winners, stock up on the laggards, and say it with me: Woot!