Most index investors recognize that investing in an index will produce no better than market returns while they are invested in the fund; however, this does not mean that those same investors cannot "outperform" the market. When I speak of index investing, I am primarily thinking of ETFs like SPY, QQQ, and IWM; however, the concepts I describe here could also apply to non-US or non-stock indexes as well. As I will discuss below, however, the US equity indexes are signaling caution, so I will focus my specific comments there.
When most people think of outperformance, they think of making excess profits during an uptrend; however, the primary opportunity most people will have to outperform over the long term is to reduce positions and avoid major downtrends when the market flashes warning signs that a downturn may be ahead. In some cases, such as 2011 and 2015, using this approach will cause you to sell some or all of your positions pre-maturely; however, small underperformance on the way up is the price you pay to tightly manage risk and avoid a much larger loss on the way down when a longer downtrend occurs such as what happened during 2007-2009 and 2000-2003.
Index Investing Is Not Passive Investing
A common misconception is that index investing is passive investing, and in fact, these terms are often used interchangeably. This is a dangerous mindset to have, however, and is not accurate since active decisions must be made about, for example, when and how much to add or withdraw to an index position, just as with any other position. Further, the decision of which markets to be invested in also represents an active decision. A good example of the importance of this is that many who cite the performance of long-term buy-and-hold investing use the US markets as their example without ever providing a methodology for why the US should have been selected over Japan (a much more viable choice during the 1980s) when the same long-term chart for Japan shows that investors have never passed the values reached in 1989.
While the administrator of an index fund may be said to passively manage the fund, investors in such funds have ongoing decisions to make that most definitely require active and ongoing judgement. These decisions include factors such as:
- What indexes to invest in
- What markets to invest in
- What regions to invest in
- When to add or reduce funds and how much to add or reduce
- What percentage of funds to allocate to each index
How Behavioral Finance Principles Can Help Create An Actionable Plan
I will describe below a number of ways that reduce the emotion associated with making decisions to add to or sell an index fund, however, first some context. A major theme of Behavioral Finance is that investors tend to buy into and hold through market tops and major declines and then sell at or near market bottoms. The market is currently signaling a potential change of trend in a clear and actionable way; however, I have seen very few calls for investors to reduce positions based on Behavioral principles even though this appears to be exactly the time that it is prudent to do so. A big problem with Behavioral Finance in the real world is that part of the reason that investors still have positions to sell near market bottoms is that few of the pundits who adhere to that approach have issued strong sell warnings near tops or described a clear methodology to do so, so I will cover some aspects of that here. As someone once said (Jim Rogers perhaps), "you can't buy near the bottom if you didn't sell near the top."
While the concepts below are presented in the context of preparing to reduce positions if the market signals further decline, all of these general techniques can also be used to re-enter positions if the market signals an uptrend is resuming. The approaches are based on minimizing counter-productive emotions and having a pre-set plan.
A general principle of Behavioral finance can be summarized as "managing emotions and cognitive biases as a key element of investment success". This principle suggests a number of ways to emotionally prepare to scale back positions if market evidence indicates a trend change to the downside may be occurring. Below, I will describe several behavioral techniques that I have found useful in preparing to exit positions which I have not heard these widely espoused by proponents of Behavioral Finance. Techniques such as these can help emotionally enable a proper strategy for reducing positions when the market signals the potential for a major decline.
Properly Anchoring Your Profit Expectations
One of the reasons many investors fail to reduce positions as a major decline appears imminent is that they look at the market value of their account as though it is money they "have" and they, therefore, view selling after a decline has begun as "losing money". They have anchored their mindset to an unrealistic profit number. In reality, what you have is what you would have when your sell indicators are reached, and for most people, reasonable sell indicators are after a market has turned sideways after retreating from a peak, which means you can never expect to sell at the exact top.
For example, if you have $100,000 in your account and your methodology for scaling out would have you sell a third of your position after a 5% decline and third at 10% and a third at 15%, then you should mentally prepare yourself by considering the value of your account to be 90,000 since the 100,000 is only on paper and would only be realized if your positions went up another amount sufficient to bring your selling points to $100,000. This principle applies regardless of your entry price since the market doesn't know where you bought your position.
Respecting Variability In A Trend
Long-term averages of market returns are highly dependent on the start and end dates of the trend for which the return is calculated. For example, someone who bought most US stock averages at the March 2000 highs waited (depending on various factors such as dividends and survivor bias) between 10 and 15 years to return to break even. The calculations of long-term returns in a market are very deceptive since almost no investors buy exactly at the mid-point of the long-term trend. Consequently, positive returns, let-alone market-beating returns, require a methodology to add to positions at major lows and reduce positions at major highs. Looking at a long-term chart of the S&P 500 below, for example, a 10-15 years trend-line can show very different returns depending on where it starts and ends.
A closely related point is that it is unrealistic to sell when you need the money or at any pre-set point such as a retirement date. Such strategies imply a fairly linear return that may occur over periods of 5-10 years, but that rarely occurs on longer time frames or the time frame when you are likely to need money. The market does not provide the levels you need when you need them and can deviate from long-term average returns for many years or even decades.
Trusting Your Process (Only After Your Process Has Earned Your Trust) And Embracing Imperfection
Inability to see into the future with great accuracy is part of the human condition. There is a long trail of people who claimed to be able to do so and who were shown to be wrong, so it is better to not emotionally committed to any particular outcome but rather to plan for as many as possible in a way that results in consistent, reliable profitability rather than maximal profitability. Techniques for following your process could include:
- Judge yourself on whether you followed your plan, not on how much money you made. This is closely related to the common saying "manage the downside and let the upside take care of itself."
- Accept in advance that any apparent trend change may be a false move, however, that it is the price one pays to protect the majority of profits.
- Plan to sell (or buy) in increments. This would have partially protected against sideways consolidations and false alarms.
- Accept that a signal from your process may be a false signal.
- Accept that if you sell and the signal is false, you may need to re-enter at a higher point.
- Resolve that protecting against a major decline, not maximizing short-term profit, is your top priority.
Applying These Principles To The Current US Equity Markets
While my focus here is on ways to prepare for a downturn, note that I am not making a prediction of an imminent downturn. I don't claim to know if one will occur soon or how long and deep it will be if it does. Rather, experience has taught me to prepare for possibilities and be emotionally and tactically ready to act if the market gives the signal to act.
That said, as of March 12, the US equity market is giving decidedly mixed signals and the risk of a change of trend is relatively high. While no one knows the future, some key observations can be made:
- The 200-day moving average for the S&P 500 is basically flat. Despite all the gyrations over the past year, the 200-day moving average is telling us that there is long-term indecision regarding the next major trend, and as JC Parets (of Allstarcharts) frequently points out, indecision and flat moving averages generally equate to higher volatility around the moving average.
- A case can be made (so far) for a rounding top and it will take significant additional buy after a major run higher from the December lows to reestablish a long-term positive trend
- A transformational piece of good news does not appear to be on the horizon; however, uncertainty in the run-up to the 2020 election could function as a gradual negative catalyst.
- The US markets have experienced a parabolic move higher since the 2017 election. Parabolic moves are by definition unsustainable since an increasing rate of ascent would imply and eventually vertical increase. Further, most parabolic moves see a downward correction of more than 50% of the move, so, while that is no assured, history suggests it is a strong possibility.
- A sideways trading range between the December lows and the current levels seem like a strong possibility. The problem with staying fully invested due to a belief in a sideways trading range is that if your sell trigger is a violation of the lower boundary of the range, then you will end up giving back what is to me an unacceptably high degree of profits. This is why I prefer to scale in and out of positions gradually.
From a fundamentals and value perspective, I look more at relative value and changes in fundamentals from a reference point. From this perspective in order to justify the roughly 20 percent increase since the election, one has to believe that the value of companies has increased by 20% or that they were undervalued by 20% or some combination of the two. While this is certainly possible and many encouraging economic events have occurred, underlying markets have not increased by anywhere close to this amount so based on my principle of looking at fundamental changes against a fixed reference point, I believe there is a strong argument to be made that equities as a whole are at or beyond fully valued.
Given this level of risk, aspects of a strategy to reduce positions could include:
- Status of your index positions above or below a particular moving average. A good place to start is the 200-day moving average since it is less influenced by short-term events. It is reportedly one of Paul Tudor Jones's favorite indicators and a nice summary is here.
- Direction of the moving average: a drop below a rising moving average is less likely to be indicative of trouble than a drop below a flat or falling moving average. Brian Shannon of the Alphatrends service and videos extensively discusses this principle for those seeking more detail.
- Status of various market indicators such as advance/decline line and related breadth indicators. These are not my favorite indicators since I find them less actionable, however, they could help define how much to reduce positions in the context of other indicators.
- Time below a moving average. The longer a move lasts, the more likely it is to become an extended move instead of a head fake.
- Classical charting principles. These typically do not rely on moving averages and thus are a good way to diversify and cross-validate your indicators.
Whether you use some aspect of these or something completely different, the critical message is to have a plan in place that you are emotionally prepared to execute which will get you substantially out of your positions if the warning signs of a downtrend are flashing red. This does not mean that such a downtrend is sure to happen, however avoiding a major decline is critical to long-term investing success as well as likely offering your best hope of "beating the market" by losing far less than those who stay substantially invested through a major decline.
Reactions To Several Common Criticisms Of These Concepts:
When reading the recommendations of others I always like to see if the author has at least minimally considered what the counter-arguments could be, so here are several that I frequently see and a brief comment on each.
Counter-Argument One: The market always comes back.
Response: This is somewhat true when looked at over a long enough time horizon and in the context of US equity markets. However, there is no law of physics that says this will always be the case or that it will come back in the time frame that you need it to. This is also inherently unscientific since there is no way to prove it wrong. If you can see into the future well enough to know the market will come back you should also be able to see into the future well enough to buy closer to bottoms and sell closer to tops.
Looking at the Japanese market however, investors who bought in 1989 before the crash (as shown in the chart below) have never broken even (ignoring dividends which are a small consolation when a market loses 80% of its value, peak to trough), so this argument also requires one to somehow choose a market that will "always come back".
Counter-Argument Two: I would owe taxes on my gains if I sell.
Response: I would rather pay taxes on gains that have a deduction (that I may never be able to offset against gains) from a loss.
Counter-Argument Three: I don't need the money now.
Response: The market does not know or care when you will retire or otherwise need money. There is no assurance that the market will be near a cyclical peak when you need the money, and you will have much more money when you need it if you avoid major declines, as well as having greater peace of mind in the meantime, a point that is often overlooked.
Counter-Argument Four: Economic fundamentals appear to be strong
Response: Markets are forward-looking and even if a change in trend does not appear to be consistent with fundamentals, trends can change for many reasons. If a trend changes and then, for whatever reason, fundamentals deteriorate (which can sometimes be caused by a deterioration in equity markets) then investors are trapped at lower prices.
Counter-Argument Five: You can't time the market
Response: This is what people with a vested interest in having people stay fully invested want you to believe, however as in the Paul Tudor Jones reference above, a simple strategy based on the direction of the 200-day moving average has done quite well with few false signals.
As the chart above shows, a simple moving average strategy, based on the direction of the moving average and extended time below it, sent false signals in 2015 and 2011 but would have avoided the bulk of the declines in 2000-2003 and 2007-2009. I'm not necessarily recommending such a strategy but it is an example of one way to create a methodology that will at least partially reduce the risk of getting caught in a major decline.
While not a strict Behavioral Finance text, a book I recommend for those who want additional related reading is It's When You Sell That Counts by Donald Cassidy. A strategy for selling is almost never discussed by mainstream market commentators unless it's in the context of something that doesn't involve a net reduction of exposure to equities, such as "re-balancing". Judging by the nature of the discussion here on SA, focusing on when to exit positions is an area where most investors can significantly up their performance by "re-balancing" their focus in order to give at least as much attention to their process for when to sell as they do for what and when to buy.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.