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By Larry Stein

In the fourth quarter of 2018, the S&P 500 recorded its largest decline in nearly a decade, falling nearly 20%. Panic selling filled the headlines. For retirees and those planning to retire soon, sudden plunges in stock prices can wreck your sleep and get your heart racing. But should you have sold stocks to cut risk?

No, not in this case. You should not cut risk unless you strongly believe you face either of these two circumstances:

    Your personal situation has changed so meaningfully that you need a lower asset allocation in equities, or,

    The stock market is extremely overvalued and there's a high probability of either an imminent recession or that the Federal Reserve will aggressively raise interest rates.

    Absent those two conditions, long-term investors should use downturns as an opportunity to grab tax losses, capture bargains, and rebalance portfolios back to their original asset allocation.

    Just because the market is falling doesn't mean you should cut risk. In fact, it may be the worst time. Let's look at the costs of cutting risk.

    The Costs of Cutting Risk

    It has become a popular phrase to "sell everything!" During the panic selling last December it wasn't hard to find those articles. While it's a nice attention-grabber, there are potential costs to cutting risk, such as:

    Taxes on your gains: If you're investing within taxable accounts, capital gains taxes can be meaningful and reduce your overall returns, especially if they are short-term gains (securities held less than one year).

    Wash sale violations: The wash sale rule has more complications than can be presented in this article, however, here's a brief description: If you sell a stock with a loss, you have to wait more than 30 days before you buy it again or the tax loss will be disallowed. For brief plunges, this makes it harder to buy back into the positioning you previously had.

    The risk of missing out on the comeback rally: This may be the biggest risk since recovery rallies often occur suddenly and when you least expect it. The December, 2018 market action is a good example. The S&P 500 fell to 2,351 on Dec. 24 and rallied back to 2,670 by Jan. 18. That's a 13.5% gain in just 17 trading days. Consider: Would you have caught such a fast-moving rally? Would the potential capital gains tax be worth the reduction in risk?

    The risk of being wrong: This is another major risk and it can be very costly. Unfortunately, investors tend to sell stocks near the bottom more often than you might imagine. Why? Because bottoms are formed in panic situations, and that's when investors tend to lose their discipline, become emotional, and sell.

    If you want to cut risk temporarily, you need to be right on two very difficult timing decisions: First, when to sell, and second, when to buy back in. Otherwise, you will probably reduce your returns.

    Dalbar, Inc., a well-known research firm, has been measuring investor returns for over 25 years. During the 20-year period from 1998 to 2017, Dalbar estimates the average balanced-fund investor generated only a 2.6% return compared with a 6.8% return if they just held the typical balanced fund. By trying to time the market, investors earned much less than half the return they could have had by simply doing nothing.

    As you can see, cutting risk temporarily is fraught with costs and risks. So many cards are stacked against you. Not only are you likely to incur costs, you are also likely to be wrong on at least one or both legs of the timing decision. Again, it's these events that tend to reduce investor returns.

    The Two Situations to Cut Risk

    Of course, there are times when it makes sense to cut risk. Two times, to be exact.

    Your personal situation has changed: Life is dynamic, things happen. Unforeseen circumstances can arise that make it logical to cut portfolio risk. This evaluation should be done independent of market conditions. If you need to cut risk, do it, regardless of what is going on in the market.

    Stocks are extremely overvalued and either a recession is looming or the Federal Reserve is aggressively raising interest rates: Stocks can remain extremely overvalued for years and continue to rise, as we saw in the 1990s. But if the extreme overvaluation is combined with a powerful catalyst - either a looming recession or an aggressive Federal Reserve - those are both reasonable times to cut risk.

    Of course, this is easier said than done. Recessions are notoriously difficult, if not impossible, to predict with any consistency. Again, even if you're right in selling, you also have to be right in buying to get reinvested. Those are two very difficult rights to get right.

    The sell/buy challenge is made much easier in a long-term bear market because you have much more time to work with. While a correction (less than 20%) may only last a few months, a bear market may go on for 12-18 months or more. Still, it's extremely difficult to know whether a bear market is going on until you're knee-deep in losses.

    The reason I focus on these particular situations for a bear market is two-fold. First, these are the events that have accompanied bear markets in the past, and second, stock valuations depend primarily on stock prices relative to corporate earnings and interest rates.

    If you're looking at political or world events as reasons to sell, you're probably going to be wrong. Why? Because the impact of these events usually run their course without significantly impacting corporate earnings or interest rates.

    Reviewing the 2018 Risk Decision

    Looking back at the 2018 downturn, would it have made sense to sell stocks and cut risk? Let's go through this thought process:

    Were stocks extremely overvalued? Not really. Stocks were on the high side of historic valuations with a price-earnings ratio of 18, but certainly not at extremes, especially considering the low level of interest rates. Moreover, earnings were on the rise and would somewhat justify the valuations. Evaluating valuations involves more than just looking at the price-earnings ratio; valuations need to be viewed relative to interest rates. On that basis, valuations were not excessive.

    Was a recession on the way? It didn't appear to be. True, the global economy seemed to be softening due in part to the U.S.-China trade dispute. Also, corporate earnings appeared to be slowing early in 2019. Despite these factors, the usual indicators of a recession were not flashing yet.

    Was the Fed aggressively raising interest rates? Not at all. Inflation remained historically modest. However, the Fed was gradually increasing the Federal Funds rate and trimming its balance sheet to more normal levels, which is another form of tightening. Part of the reason stocks staged such a strong comeback was due to the growing belief that the Fed would be more patient and not raise interest rates substantially until there was clearer evidence of a stronger economy.

    Don't Try to Time the Market

    If you need to cut risk for personal reasons, do it. But if you're trying to time the market and cut risk temporarily, be aware of the costs and realize that you may be wrong. And, even if you're right, you may not execute the trades well enough to warrant the taxes incurred. As a result, you will end up (like most people) reducing your returns.

    Keep in mind that even if you bought stocks at every major top and never sold, you would still have positive returns over the long term. It's also important to note that most decades only experience one or two bear markets. Most of the time stocks are in a long-term uptrend even though the market climbs what is well-known as "a wall of worry." Moreover, even if there is a bear market, investors with balanced portfolios of stocks and bonds tend to recoup their losses within a couple of years (usually not a terrible price to pay). These facts underscore the need to be disciplined during market downturns and resist selling unless absolutely necessary.

    On the other hand, even with so many cards stacked against you, if stocks are extremely overvalued and either a recession or rapidly rising interest rates are on the way, it can be worthwhile to reduce your risk. You might sleep better and feel better about your retirement.

    Retirees and those planning to retire soon need to be especially vigilant about risk management. Large declines can impact your retirement, especially if you are withdrawing money from your portfolio for living expenses. However, given the potential costs as well as the chance of being wrong in your sell/buy decisions, it's just as important to be disciplined about cutting risk.

    About the author: Larry Stein is the Chicago Ambassador for the national CFP Board and the author of two published books: Peace of Mind Investing and Value Investing. In 2010, he created Disciplined Investment Management to be a different type of firm, combining deeply personal planning and low-cost, risk-managed indexed investing. There are no products and no commissions. Most clients are either retired or planning to retire, with an emphasis on how to make their money last.

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