Why it is a bad idea to get out of the market in a downturn

Doesn’t it seem reasonable that when the stock market is dropping month after month you should get out, avoid more losses, and wait for the upturn? Unfortunately, this is just what many investors do. Once they are out of the market, they often don’t begin investing until well after a recovery has occurred and it looks very apparent that the market decline is over.

Such a strategy is very hazardous to your wealth, says John Bogle, founder and former chairman of The Vanguard Group, one of the largest U.S.mutual fund companies. That’s because the market tends to rack up most of its gains on just a handful of trading days. If you miss those days, your profits are diminished considerably. In a speech Bogle gave to the Risk Management Association in Florida last year, he noted that the Standard & Poor’s 500 Stock Index increased from 17 in 1950 to 1,540 as of his speech in October (it recently stood at 1,282.83). “But deduct the returns achieved on the 40 days in which it had its highest percentage gains – only 40 out of 14,528 days! – and it would drop by some 70 percent, to 276,” Bogle said. Any investor who chose to sit out part of the year ran a real risk of missing some of those 40 days that accounted for 70 percent of the market’s gains. Other studies have shown that if the best five days for the stock market each year are excluded, an investor from 1966 to 2001 would have had a loss rather than an eleven-fold gain.

The managers of Tweedy, Browne Co., which operates three value-oriented mutual funds, recently warned against jumping out of the market during downturns. Not only do such moves create capital gains taxes for taxable accounts, most market gains come in quick bursts that are not at all predictable. “We believe that if you are not invested during these rather brief upswings, your long-term compounded return can suffer dramatically,” they said. This means that during market declines investors should hunker down and wait for the inevitable upswings.