Uncertainty & Risk Premiums

The COVID crisis injected uncertainty into the markets and many investors earlier this year. While investors watched as the virus spread, many wondered how long this might play out and whether they should sell some equities and park that money in cash. Other investors didn’t wonder at all – they sold first, and asked questions later. What began as the fastest bear market in history ultimately turned out to be also the fastest recovery in history, giving investors another valuable demonstration of how difficult it is to successfully time the markets when they get scared. 

In times like those, however, advisors can add some of the most value to investors – both through strategic and tactical means. Strategically, advisors can help calm investors and keep them focused on the long-term benefits of staying disciplined. Tactically, advisors can help clients achieve the benefits of rebalancing in periods of dislocation and harvesting losses for future tax write-offs. 

Pinpointing exactly how much value those processes add to investors’ lives can be difficult. However, given the massive number of do-it-yourself investors on their platform, Vanguard recently took up the task of trying to quantify the answer to one of those methods, by looking at the inverse: how much did investors harm themselves if they surrendered to fear and moved to all cash during the crisis? (Read the full study here.)

Among the findings, a few notable things stood out: 

• Between the peak (Feb 19, 2020) and the end of May, less than 0.5% of Vanguard investors in either defined contribution plans (like 401ks) or in retail self-directed accounts panicked and traded to all-cash at some point during that time frame. 
• The median equity allocation of those so-called “cash panickers” as of December 2019 (before the panic) was 70-75%. 
• Those investors were on average in their mid-50s and had been Vanguard clients for at least 12 years. 
• As of the end of May, approximately 85% of the “cash panickers” (including many who got back into stocks during the time frame) were worse off for having made the move to all cash, than if they would have stuck to their original equity allocation all along.

That study highlights one of the fundamentals of investing: Risk premiums – the long-term “excess returns” an investor captures by investing in riskier assets, above and beyond what you should earn in less risky investments. To receive the risk premiums available from investing in stocks, you must be willing to accept risk, even during periods of uncertainty. The only investment without risk (aka the “risk-free asset”) is a US Treasury bond, and it currently pays 0.66% for the next ten years. If you desire more return, you must accept more risk.

This basic tenet has produced some important insights regarding fear and investing over the years:

• Richard Bernstein said, “No one ever grew wealth being scared.”
• Warren Buffett said, “Be fearful when others are greedy and greedy when others are fearful.”
• When an investor’s concerns peak and they decide to sell all or a portion of their equities to avoid further downside, they have effectively complicated their investment process by committing to another (potentially tougher) decision: when to get back in. 

The next time volatility rears its ugly head, whether that’s sooner (e.g. closer to the election) or later (next year or beyond), we encourage readers to remember the findings from the Vanguard study, as well as the fundamental truths and advice. If you need help or need a reminder, that’s what we’re here for.