Why doesn't common investment advice include the idea of pulling out of the market during downturns?

Question

The most common advice goes somewhat as follows:

1. Every month, save as much money as possible after paying down your high interest bills
2. Put that money into an index fund
3. Reinvest dividends
4. Enjoy your retirement in 50 years

But it seems like there's no recommendations around pulling out of the market while volatility is high. For example a simple rule could be something like this:

1. If your index fund has gone down by more than 5% from its peak, pull out into bonds
2. Once the market has come back to its original peak, get back in

This would've been helpful in many historical periods:

1. During the dotcom bust the market has been going down from 2000 to 2003. Pulling out and waiting would've helped you avoid the lost decade
2. During the 2007 stock market crash you would've likewise avoided piling money into a falling market
3. During the COVID crash you would've pulled out around March 1st and avoided investing during the most volatile month in 20 years

In all three cases the market eventually recovered but... what if it doesn't eventually, similar to how Nikkei took 30 years to go back to its 1991 peak? Are there any downsides to the "pull out to be safe" strategy that I'm not seeing?

A more advanced strategy would be to buy the dip but this is getting dangerously close to trying to time the market rather than simply avoiding catastrophic loss.

Answer 1

Getting out of the market is a good idea if it will go down after you sold (and if you buy back early enough). Yes, if you can do that correctly, you earn money.

Having a loss of 5% before you sell is (probably) not an indication that it will go down further.

Testing your strategy on this year's Dow Jones, you would have sold 2 times:

• sold on 18.6.21 at 33.270, down > 5% to the previous peak on 10.5.21 at 35.090
• bought back after 1 month on 23.7.21 at 35.095
• sold on 20.9.21 at 33.615, down > 5% to the previous peak on 16.8.21 at 35.630
• bought back after 1 month on 20.10.21 at 35.670
• last friday it was down 4,97% to the previous peak, so maybe today you would sell again. Yes, omicron variant might start a new downtrend where it would be smart to pull out - or it doesn't.

So you would have taken a 5% loss 2 times, and gained the profit from holding bonds for 2 month.

Incidently, the index didn't actually fall further than those 5%, e.g. both times the prices you sold at were the minimum prices for the rest of the year. So basically, while everyone else is trying to buy at the lowest price, you found a way to sell at the lowest price.

Answer 2

Because such a strategy, when back-tested, probably fails. Badly.

5% off peak, I sell. I watch the selloff reverse and buy back at the peak, perhaps days later. I just lost 5%. 5% selloffs are common enough that this plan may very well yield a zero or negative return over time.

I recommend you read Is it true that, "just ten trading days represent 63 per cent of the returns of the past 50 years"? if only to understand the value of buy and hold.

On a personal note, I retired in 2012. I was always an aggressive investor, nearly 100% in stock. After 2013 (a 32% gain), I considered taking my own wise advice and having a mix that was more sane, 25% 'cash'. Since then, the market, as measured by the S&P, has tripled. Being out of stocks for some fraction of one's retirement money helps to bridge the gap through market crashes, but at a cost. Losing 5% here and there? Hard pass.

TL;DR - because any sell/buy requires you to be right twice. Over the long term, buy and hold has proven superior.

Answer 3

The other two answers (the difficulty of timing) are both correct, but there is another issue: this approach requires you to change from being a passive investor to an active one, because you need to check the index movements semi-regularly and work out if your target movements have happened.

Passive investment is pretty straightforward: you can send money to a specific account on a regular basis, tell it to reinvest dividends if appropriate, and not think about it for years on end. When you finally need it, sell. This makes it a really simple strategy that is easy to follow, requires no expertise, and can be recommended to pretty much everyone. It may not be perfect, but it's better than putting it in a savings account, while critically not requiring much more work than would be needed for the savings account.

Once you start adding active elements - every month check the direction of the market and then move money accordingly - it becomes trickier to follow, it requires more time and attention, and it is more likely people will give it up as too complicated, or get confused about what to do when. This makes it less useful as general advice, even if it might have been marginally better for people who follow it precisely.

Answer 4

Your hypothesis is valid but unfortunately, it's highly impractical for most people because it requires a lot of skill if not some good luck.

AFAIC, if you're risk averse, a better approach would be either to utilize some hedging and/or to transition from long to short as the market drops.

Hedging reacts to the drop and you can adjust accordingly. You don't have to 'time' the market.

With transitioning, it's not all or nothing. You scale out of long positions and increase short positions. If you're wrong, you scale back in. It's not binary.

I've lived through four bear markets and it took me until the 2008 Global Financial crisis to get it right. And yes, I closed a large amount of my long positions in late 2007 and went net short for the next two years. It can be done but you need years of experience, the conviction of your beliefs, and the ability to admit you're wrong and reverse your position if necessary. You can't use hindsight and look back and say 'you could have done this and avoided the big losses'.

Answer 5

Because there's better (and easier) advice: adjust your asset allocation based on your actuarially expected future. When you are young, you can have most of your long term investments in high-volatility investments because you (on average) have plenty of time to ride out any downturn. As you age, you should gradually transition to less volatile investments. By the time you have to withdraw in retirement, you should have adequate resources in very low risk investments that won't fluctuate with the market.

Now if there is some horrible long-term market downturn when you are young, you just wait it out as per normal. If there is some horrible long-term market downturn while you are are middle aged, you can cautiously still expect to retire and live off of your low-risk investments if necessary while waiting for the market to recover. If there is some horrible long-term market downturn when you are elderly, you don't care because your money is in investments that aren't moving anyway.

Is this 100% safe? No. There is the situation where you are forced to start withdrawing your savings much earlier than expected, for example if you are forced to retire much younger than expected due to medical issues. There's also the situation where the downturn lasts forever or possibly even 'safe' investments turn out not safe, e.g. zombie apocalypse or government collapse. Obviously the ideal investment strategy would avoid those, but the only one that seems to do that involves a time machine.

But "target date funds" are easy to come by and work pretty well for people with average lives.

Answer 6

There's multiple angles to that.

The first is that your advise is about long-term investment. That strategy doesn't care about short-term loss. Sure your stock might tank a couple % today, but looking at it over a year or three, it's in the plus and that is what matters. Short-term investment is a different game requiring a different attitude and skill set.

The second is that it is very difficult to predict a downturn. The stock market goes up and down all the time. By the time you can be fairly sure this isn't just a blip but an actual downturn, you are probably already fairly far down the curve. You don't know where it will bottom out, so you risk selling near the low point. The general advise of traders (I used to work for some, but that's long in the past, the wisdom might have changed since) used to be to sell before the peak and buy before the lowest point. Because if you try to hit those points, you will certainly miss them, and the markets have a tendency to turn against you faster than for you.

The third is that when you are faced with a general economic crisis the question isn't just if you should pull your money out, but also where else to put it. If you just pull out and keep it in a bank account, you are betting on your currency staying valuable and that bank staying in business. If you put it into another investment, what tells you that investment won't go down next? That is why long-term investments generally try to ride out the crisis. Sure, this year and next, the economy is shit, but it will eventually recover, it always does.

Answer 7

Are there any downsides to the "pull out to be safe" strategy that I'm not seeing?

Others have already mentioned the problem with timing the market. Depending on your country and investment platform there are other things to consider as well.

• Taxes: Once you sell your investment you might have to pay taxes on your gains.
• Fees: Investment platforms might charge fees for selling and buying.

Answer 8

So brokers don't get sued.

Brokers need a "gold standard" best-practice. Timing the market really does not work for that!

It's very common to have disputes between investors and their brokers, to the effect that the broker invested their funds improperly and should have rather large liability for the losses.

As such, it's very much in brokers' interest that there be industry standard advice - the broker can say "Hey, look - I followed best practices here to the letter".

What you're talking about is "Timing the market". It seems a super-obvious thing to do when looking at past data, when able to see what happened next. But it is much more difficult and error-prone when you are actually IN IT, i.e. it's December 6, 1941, anything special going to happen tomorrow? You don't know.

And that's the problem. You can personally time the market, and if you're right, congratulations, and if you're wrong, you willingly eat that. But it's a whole different kettle of fish when you're a fiduciary handling other people's money. Now, if you do something intuitive like that, and you're right, your customer benefits. But if you're wrong, you get sued.

It would be a macroeconomic apocalypse

Imagine someone came out with a reliable algorithm for predicting downturns, and it became common/standard practice to use that to "time the market".

So, the conditions emerge, the algorithm fires, and everyone dumps all their stock at once. What happens to the country?

Stocks are a mad rush to the bottom - everyone is underbidding each other trying to panic-sell, hoping for the rare buyer willing to "catch a falling knife" - meanwhile smart money is offering pennies on the dollar, and getting it from fools, amateurs and the desperate. This is where you hear about people's retirements being "wiped out" in the collapse, because they psych themselves out into "selling low" when they should just stay put.

It could recover fully... but before that, it would light off a national panic, hoarding, looting, martial law, and much worse - even a communist or fascist revolution if the wrong guy gets in front of the wrong microphone. That would also have a huge destabilizing effect on governments around the world. (Taiwan and South Korea would be overrun in days; instant Cold War with China). The world market is so intertwined, that all that stuff would do such damage to the economy that could take decades to recover.

Having everyone all do the same "best practice" in stock movements is not a good practice at all.

Answer 9

Because you aren't a professional investor, you shouldn't try to time the market. What you should do is limit the opportunity cost (your own time - spend that making money while your money silently works for you) as well as tax burden. So "buy and hold for as long as possible" becomes an incredibly simple yet difficult-to-improve strategy

Answer 10

When you go in and out of positions you are more 'trading' than investing. If you simply change your 5% to .5% you would have a day trading strategy. A poor one, but still. One thing to look out for is the speed at which the markets go down. Markets tend to trickle up but downside moves can be instantaneous. Hence why puts are more expensive than calls. Thus investment strategies tend to factor in short term volatility for an expected long term return.