It seems fitting, if not ironic, that in the year 2020 hindsight is emerging as an important theme. The COVID-19 pandemic has taken the world by storm and as it continues to unfold into a full-blown global health and economic crisis, one of the perennial challenges confronting investors and advisors face is what an appropriate response should be.
At DALBAR, we have witnessed many significant events manifest as market drops in our 44-year history. By all measures, however, the recent fall of the major US and global equity markets has been unprecedented. Not since the Great Depression have stock markets fallen to the extent they have, nor have so many investors been caught off-guard by the type of shock they are now experiencing.
Building on the decades of research that the Quantitative Analysis of Investor Behavior (QAIB) has taught us about investor psychology – especially in falling markets – we know that investors typically flee at the wrong time and if they come back at all, it is usually at a point long after the critical rebound window has closed.
Of course, as any seasoned financial advisor knows, convincing investors to stay invested, especially in the face of such precipitous declines can be a challenge especially if (or when) panic sets in. To help address this phenomenon, a new online tool was launched last year at DALBAR, called the Investor Panic Relief Tool or i-PRT.
Although there are many things that everyday investors cannot control about the direction or performance of the market, there are still prudent, rational actions that can be taken to facilitate success. In fact, of the three options available to investors during this market turbulence, namely of being optimistic and investing aggressively; being pessimistic and staying out of the markets and doing nothing, the best course of action according to the data is not to panic and do nothing, which for many investors is easier said than done.
When we launched the DALBAR i-PRT, we understood that the value of this tool would be made clear when – not if – a market correction occurred. While we did not foresee a correction of this magnitude taking place in 2020, the important insight here is that neither did so many others.
History shows that sharp market declines rarely get announced prior to them showing up and the recoveries from those events – the so-called bounces which are crucial to restoring losses – also show up relatively quickly and only become clear once they are long gone.
How i-PRT Works
At its core, the DALBAR i-PRT is intended to help advisors provide investors with an alternative to “doing nothing” even though the data has shown doing nothing to be the consistently sound choice. By incorporating insurance against sharp downward moves, the i-PRT strategy takes advantage of index puts, which then enables investors to weather short term downturns while simultaneously remaining invested to take advantage of natural rebounds.
It is worth reiterating that the biggest mistake that panicked investors make is failing to reenter markets after a downturn. In doing so, they lock in their losses, miss out on the recovery and are then prone to being haunted by the “Doom Echo” – a form of loss aversion that will hamper them from stepping back into the markets. This hurts investors and is certainly something financial advisors would prefer not to see happen to their clients or the investing public.
Learning from History
While the current crisis is still unfolding, the extraordinary measures taken by the central bankers and companies around the world has many experts positioning for a very sharp recovery when a turning point is reached.
DALBAR has analyzed every major market downturn over the past 90 years and the pattern is a familiar one: this too shall pass. We are also confident that a bounce is likely to take place at some point however confirmation of the turning point will only be knowable once we’re well past it.
With better tools like DALBAR i-PRT at the disposal of investors and advisors, it is now possible to learn from history instead of repeating it, which is something we can all look forward to. We encourage advisors and investors to learn more about the DALBAR i-PRT and see how taking the right actions can keep portfolios safe in these volatile times.