Panic Is Not a Strategy—Nor Is Greed
Updated May 10, 2012
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Key Points
- Originally publishing in 2008, it's time for a refresher about the perils of panic.
- Asset allocation, diversification and rebalancing are as close to a "free lunch" as you can get as an investor.
- In a world where time horizons have shrunk precipitously, think longer-term.
If markets are good at one thing, it's reminding investors that they don't go up uninterrupted forever. We witnessed several bruising corrections in 2011 before the market's strong rally between October 2011 and April 2012. As the chart "Fear Spikes Again" below illustrates, the CBOE Volatility Index® has picked up again, but remains below the unparalleled heights of the 2008 credit crisis and the more-recent elevation in 2011.
Fear Up, But Well Down From Highs
Source: FactSet, as of April 20, 2012. The CBOE Volatility Index ("VIX") is a registered trademark of the Chicago Board Options Exchange. The VIX Index shows the market's expectation of 30-day volatility. For more information on the VIX, visit www.cboe.com/micro/vix/
We're always quick to remind investors that neither panic nor greed is an investment strategy, and that the best foundation to help protect a portfolio against the unpredictable is having—and sticking with—a long-term strategic asset allocation plan.
Mindset matters: strategic trumps tactical
In reality, investors should rarely, if ever, react to a dramatic short-term move in the market. As intriguing as it may seem to try to catch bottoms and get out at tops in order to reap big profits (or so you think), the "tactical" (or shorter-term) approach to investing has its limitations ... and its risks.
We believe it's the "strategic" asset allocation decision—and the ability to stick with it through the discipline of rebalancing—that will ultimately reap the greatest rewards. These decisions are not a function of short-term market gyrations or forecasts (mine, yours or anyone else's), but are tied to your risk tolerance and long-term goals. Developing and maintaining the right long-term asset mix is by far the most important set of decisions a client will ever make.
Never before has information about the global economy and markets been more readily available and disseminated. As a result, global markets have become very interconnected. In turn, our reaction mechanisms have kicked in, and investor time horizons have shortened dramatically—but not necessarily to our advantage. Yes, the long term is really just a series of short-term events, but it's how we react to them that decides our ultimate fate as investors.
Asset allocation and diversification: investors' "free lunch"
One of the most important areas where Schwab offers advice is the development of a long-term strategic asset allocation plan. Many investors assume that their position along the risk spectrum from conservative to aggressive is largely based on their age and time horizon. But a more important factor is their risk tolerance. Also important is judging the difference between an investor's financial risk tolerance (their ability to financially withstand volatile markets) and their emotional risk tolerance—a spread that's often quite wide and only acknowledged during tumultuous market environments.
I've known plenty of older investors who thrive on the risk associated with an aggressive investment stance. I've also known plenty of young investors who can't stomach any losses. Too often, investors use a rearview mirror to make their investing decisions, by looking at past performance as a guide to future results. A mirror is a valuable tool but only when turned on yourself to judge your own circumstances—tolerance for risk, time horizon, income needs, etc. As I've often said, there are very few free lunches in investing. Asset allocation, diversification and periodic rebalancing are as close as you get.
Risk tolerance: Know what you can stomach
In the chart "Schwab's Strategic Asset Allocation Models" below, you'll see our long-term recommendations regarding different asset classes for three types of investors: conservative, moderate and aggressive.1 Note the vast differences in allocations to riskier asset classes, including international equity, as you move up the risk spectrum.
Clearly, over the long term, given the better performance by the riskier asset classes, a more aggressive allocation has historically reaped higher rewards in terms of returns. But there is a dark side to an aggressive posture's higher returns—the risk taken in getting there.
