Long-term clients and readers of this newsletter will recall my occasional discussions of “LifeBoat Drills.” Unlike when you board a cruise ship and learn what to do in case of emergency, my LifeBoat Drills focus on what not to do in case of a market emergency.
What’s a market emergency? This is when you learn that the market has recently declined by, let’s say, 10%, and you hear experts are predicting it will go down more. Then, confirming these opinions, the market goes down another 10% or so. Now, your worries are turning into fears of a market collapse, a monetary collapse, or a complete economic collapse.
Combining expert opinions with your fears has you debating with yourself whether to get out of the market before you lose the rest. There is an investment term for bailing on your investments at this point in the cycle: “capitulation”. Capitulation is defined as the act of giving up or surrendering.
Should you capitulate when the market is down 20-30%? My emphatic answer is NO! Let’s discuss the logic behind saying no to capitulation.
The Logic Behind Saying No to Capitulation
When you pay a certain price to buy an investment you assume that the investment has a certain value and you expect that value to increase to a certain level in the future. When the price begins to go up does the remaining value to you also go up or does it go down? Think about it: when the price goes up the remaining value to you actually goes down because there is less remaining future growth.
The opposite is also true. When the price goes down the remaining value to you actually goes up—there is more growth available in between the lower price and the future value of the investment.
What about Risk?
Let’s think about it in terms of risk. One’s typical intuitive response when the market is heading downward is that risk is rising. The fear of continuing rising risk leads to capitulation.
But is risk really rising when the markets turn downward? No, after a 10% decline your risk is actually lessening because your future returns are growing–all the more so when markets are down 20% or 30%. Granted, it is not easy to maintain this perspective when markets are tumbling and the news is gloomy, but it is the correct perspective from a logical point of view and also from a historical results-oriented point of view.
Paraphrasing a quote I have written before: during a Bear Market investors who have lost all faith in the future (i.e., the capitulators) sell to investors who recognize that declines are temporary and that “this too shall pass.”
In summary, when we are asked to endure the next wave of market declines, recognize that the decline will be temporary (they always are!) and don’t be a capitulator. My experience indicates that capitulators end up regretting their behavior because their returns will lag behind going forward. JR