Why You Should Stay in the Market Despite the Crash

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What a Week!

The market had its 7th straight trading session of decline and is now at a low it has not seen in 5 years down 39% from its year ago peak.  All 30 Dow components were down today.  Bad news continues globally as the financial issues are showing up in Europe and Asia.

As Americans sleep the Japanese Nikei index is opening down 11% and Iceland had to nationalize its largest bank.

What Now?

Don’t panic.  Don’t sell at a bottom or what maybe near a bottom.  Yes you are seeing bad news everywhere and it is hitting everyday America hard.

“I lost $20K in 1 day.  I did all the right things.  I forwent driving a nice car and living in a nice house for my future.  I am losing money faster than I’m earning it.”    -colleague in my office building

It is tempting to remove your money from the market to stop the pain.  Timing the market is a difficult thing.  You probably saw losses in your retirement and other investment accounts down 20-30% over the past 3 months and you think you’ve got to sell.  Right?  Wrong.  Some such as TV personality Jim Cramer will tell you to sell everything if you need money in the next 5 years.  This is dangerous advice for a few reasons.

Cashing Out Your Retirement Accounts is Expensive

Depending on the type of account removing money from your retirement account can be expensive.  

• 10% penalty on ALL withdrawn funds
• The distributions will be taxed as ordinary income.
• Loss of compounding tax-free.  Money withdrawn can’t be put back in later.  For example if you earn 10% in a tax-free account, you’d have to earn 14.2% [10%/(1-.30)=14.2] in a taxable account to get the same return (assuming a 30% tax bracket).  If you read my post - The Rule of 72, 114, 144, you’d see how powerful and important this is.

Depending on your tax bracked you could be left with just 60 cents on the dollar after penalties and taxes.  In addition you’ll lose the power of compounding tax-free in years to come.  I know you’ve felt alot of pain in the past week, but the odds are that most of the pain has passed.  Their could be more, but if you time it wrong you could miss out on short-term rallies and sell at the bottom. 

Be Patient

You may be thinking we’re in a recession (you’re probably right) so you should get out of the market.  The past few days of torment and losses don’t help.  The fact is that since the end of WWII, each recession has lasted about 10 months.  Each subsequent expansion has lasted a little over 5 years.  The beginning of a recession is never really pinpointed until the economy is already somewhere in its cycle.  They also end without warning.  You don’t want to take your money out towards the end of a recession and a subsequent expansion.  In other words, you could mistime it and miss the big gains.

The chart below illustrates mistiming by investors.  It shows the market decline and subsequent bull market.  As you can see investors withdrew their funds and hoarded it in cash.  Those investors missed out on half of the subsequent bull market and were cashing out near the market bottom.

Money Market Funds vs Total Fund Assets

On average the market has given around 10% return annually.  That factors in down years as well.  You must endure the bad to reap the good.  Moving your money into cash or bonds could leave you growthless after taking inflation into account.  By all means move in and out for trading, but not for investing.

The Fear Factor

The Volatility Index or VIX is at an all-time high.  The VIX is often seen as a “Fear Index”.  It has an inverse relationship to the market.  See the chart below.

Looking at the above chart, what do you suppose might happen when volatility comes back to more sane levels?  We would expect that their would be a bounce in stock prices as volatility subsides.  It may not make it back to the all-time high 1 year ago, but you would expect some big gains from this level.  The downside risk from this level is relatively low as we maybe in an oversold market.  The big drops are probably behind us even if there are some more drops.  If you need the money near term, wait until you get some spikes and the VIX comes back down and sell into short-term rallies.

My Strategy

Besides my trading account, I’m all cash and gold.  I will be selling some gold as I think the “fear factor” is going to start coming down sometime in the next month or so.  My cash is short-term.  I will be putting it back into the market once I see the volatility (VIX) come down and see some more buying volume.  At that point I will be double-down long in the market.  

Sometimes you have to be brave and calm when trading.  I bought a foreclosure house close to (if not at) the bottom of the housing market when others were afraid to do so.  Time will tell, but that decision probably added the most to my net worth in recent years than anything else I’ve done.

Keeping things simple I’m going to focus on the below ETF’s:

• SSO     Double Long   S&P500
• UWM   Double Long   Russell 2000
• SAA     Double Long   S&P Smallcap 600
• DZZ     Double Short  Gold Double Short