STOP: A Brief (But VERY Important) Detour

While dissecting The Relaxing Retirement Formula™ over the last few weeks, and sharing the first three Principles and Guidelines to follow to help you answer the question of where to position your investments to produce the long term rate of return you need to earn while experiencing less volatility and paying less taxes to the government, I’ve focused on what TO DO as opposed to what NOT to do.

Today, however, before I provide you with Principle and Guideline #4, I’m going to take a brief detour and discuss what I’ve witnessed to be one of the most destructive theories and behaviors I’ve personally witnessed among retirees over the last 24 years.

In short, in order to clarify a principle, sometimes the most effective way to do so is to contrast it with what NOT to do.

Today’s Strategy is an example of that.

Whenever the stock market experiences a correction, investment discipline gets seriously tested.

It’s no picnic! Experiencing a 20-30% market correction at this stage in your life, where the money that you’ve built up over the years must now support you, is tough to take.

The emotional temptation is to fold up your tent and “wait it out” on the sidelines, i.e. sell everything and move it to cash.

This temptation is what is known as ‘market timing’ pure and simple. As much as folks don’t want to admit that they’re timing the market, there is no other way to classify it.

It stems from a belief, rational or irrational, that you know what markets are going to do in the short run and the long run.

By selling everything and moving your investments into cash, you’re making the assumption that market prices will continue to go down until some period of time in the future when things “settle down”. And, when things settle down, then you’ll get back in.

Much of this thinking and strategy stems from the notion that there is a small group of people out there who are “in the know”, who are outsmarting markets. They have a sixth sense and know when to get out and when to get in. They don’t suffer these losses like us “average” folks. They’re too smart for that.

Do you believe that? Unfortunately, too many people do.

If it was true, then how could John Paulson, famous for making hundreds of millions of dollars betting on the collapse of housing prices in 2008, have lost over 50% for his investors in 2011?

How could Harvard University’s massive endowment fund, run by world renowned money managers, have lost over $10 Billion during the 2008-2009 market drop leading to a complete change of direction for the most prestigious university in America, including sizable staff layoffs, discontinued programs, and cancelled projects?

Why Market Timing Is a Bad Idea

In theory, the concept of market timing sounds like the way to go. However, there are many reasons why engaging in the practice of market timing is a bad idea. Let me illustrate a few for you:

  1. Selling out after the market has suffered a downturn virtually insures that you will sell low and then buy high, the opposite of what you want to do. Why?

Let’s say that a sharp decline in the equity prices leads you to sell off your stock based investments due to your fear that their prices will continue to drop.

The question to ask yourself is what will have to happen in order for me to feel comfortable enough to invest my money back into my equity investments”?

The typical answer is “when the market settles down and isn’t in a downward ‘trend’ anymore.”

Well, in order for that to happen, the market will have to have several consecutive days or weeks of price appreciation.

In short, in order for you to feel comfortable enough to get back in, the market will have to have demonstrated sustained appreciation over time.

However, by the time that happens, you will have missed the appreciation and bought back in at the high! You will have been out of the market when the appreciation occurred.

In short, you will have sold low and bought high, the opposite of what you want to do.

  1. Historically speaking, there are typically 8 to 10 days in a year where market movements really influence your overall rate of return. In other words, during most days in the market, movement is up or down 1% or less.

However, there have typically been 8 to 10 days in a year where that movement is greater than 1%. And, those are the days that really influence whether you’ll have a poor year, an average year, or a really good year.

If you sell everything and move onto the sidelines after a market downturn has taken place, you run the risk that you will miss one or more of those days on the upswing.

And, missing those days could be the difference between you achieving your “needed” overall rate of return or missing it. Consistently missing it could mean running out of money too soon.

  1. Most importantly, once you start down the road of market timing, you can’t stop.

You will have bought into the theory that watching and reacting to daily or minute-by-minute moves in the market is the solution to your long term investment goals.

Your investment decisions will be 100% based on emotion, not a carefully thought out, disciplined, long term strategy.

Discipline and rational thought goes out the window and you will spend your life in reaction.

All of the legends of investing disagree with market timing. They have instilled in all of us to have a long term strategy in place and to remain disciplined in spite of short term movements in the market.

This doesn’t mean having “blind faith”. What it does mean is, if you’ve done your homework and you have a carefully thought out, custom tailored plan, i.e. The Relaxing Retirement Formula™, proactive discipline is the solution.

Proactive Discipline

At this stage in your life, where the money you’ve saved is now supporting you, your approach has to be rooted in “proactive” discipline:

  • The discipline to tally up the amount of money you need to withdraw from your investments each year over and above what you receive from social security and your pension, i.e. your “level of Retirement Bucket™ Dependence
  • The discipline to calculate the investment rate of return you must earn in order to produce lifestyle sustaining income (that keeps pace with inflation)
  • The discipline to set aside the money you’ll need to spend over the next few years in short term instruments which are not subject to market volatility (even when the market has just jumped up and you feel as though you may be missing out)
  • The discipline to properly allocate your investments among many different styles of investments, each with its own goal, as opposed to being lured by what is supposedly “hot” or “doing well” at the moment
  • The discipline to strategically plan ‘where’ you’re going to hold your various investment holdings to take advantage of lower capital gains tax rates vs. higher ordinary income tax rates
  • The discipline to consistently evaluate the allocation of your investments and make unemotional, rational adjustments
  • The discipline to objectively monitor the performance of each individual investment vs. its peer group, and make adjustments when necessary

As I hope you’re seeing, it’s imperative at this stage in your life’s “retirement game” that you have a system of decision making with regard to everything that happens in your financial life.

Without it, you’re at the undisciplined mercy of the “news of the day”, or the latest sales gimmick.

Don’t fall prey like the undisciplined masses.

Next week, let’s move on to Principle and Guideline #4.

Don’t miss it!