Key takeaways
- Dr. Bernstein is co-founder of Efficient Frontier Advisors, ($ 25Mn min investment) has authored over 10 books on investing and his insights are sought after by the world’s leading financial media
- Most people tend to panic & sell their equity investments when the market is falling assuming there is no end to how much it will fall. They believe that by selling during a downturn they will minimize or cut their losses but this is a costly mistake.
- Even if we don’t panic, we don’t know what to do proactively instead
- If we are mature & decide it’s a good opportunity to buy, it’s hard to know how much more to buy
- Some of the most respected investors in the world recommend buying more when the markets are down
- Do nothing different: The most basic way to deal with a downturn, he says, is to do nothing different from what you were doing before the downturn. Be unfazed or unshaken. If you were doing an SIP before the downturn just continue the same SIP as before
- Value averaging: A better approach than just continuing your SIPs is to take the Value averaging approach researched by Harvard Professor Michael Edleson
- Another well-known way to take advantage of the downturn that Bernstein also advocates portfolio re-balancing
- Dynamic asset allocation: Another less known yet powerful technique he suggests looks to take even more advantage of the downturn and overbalance your portfolio. Dr. Bernstein suggests a 1:5 ratio in the context of the extent of the decline as a thumb rule for this.
The dilemmas many face during a market downturn
During a downturn, we tend to listen to all the fear mongering going on in the news & on social media and being human we get swayed by all of this. We start to panic wondering how much more loss we will have to endure if the market continues dropping the way it has. With the seemingly noble & wise intent of cutting / reducing our losses from such a continued free fall, we sell a lot of equity. Indeed, I heard a story of one person who pulled out approx. 23 crores of their investments during the 2020 crash !
However, if the Gurus of investing are to be believed, selling equity investments during a downturn is just short of suicidal. A good investment advisor or coach can help tremendously with this by being an objective sounding board for your investment decisions & thereby (hopefully) preventing you from doing any rash selling out of fear.
Even if we don’t panic & sell and know we should re-balance our portfolio, we don’t know how to re-balance in the context of an SIP – because with an SIP we haven’t yet reached our target allocation – so in effect there is no target allocation to re-balance to
Even if we are not swayed by the news or social media & on the contrary believe this is a GREAT opportunity to buy, we still don’t know how much to buy.
In this article I shed some light on solutions to the above dilemmas based on the writings of Dr. William J Bernstein.
How some of the greatest investors view market downturns
Compared to the average retail investor, most experienced or savvy investors know that significant gains are to be had if one can keep their wits about when the markets are falling and others are losing their head. Here are a few quotes from legendary investors on this topic below:
“When major declines occur, however, they offer extraordinary opportunities to those who are not handicapped by debt,” – Warren Buffet
“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell” – John Templeton
“A market downturn is the best opportunity to buy great companies at bargain prices.” – Peter Lynch
This article explains 4 different approaches to deal with a market downturn as per Dr. William Bernstein. In particular, this article highlights two potentially powerful yet less known ways recommended by Dr Bernstein’s on how to capitalize on market downturns.
Who is Dr. Bernstein & why you might want to heed his advice
Dr. William Bernstein, co-founded investment firm Efficient Frontier Advisors. To be able to engage his firm, one needs a minimum investment of $25 Million. For those of us who don’t have $25 million, he has written over 10 books on the subject of personal finance & investing. 😊 He is also frequently interviewed by media houses such as CNBC. His insights have been featured in major financial publications such as The Wall Street Journal, Morningstar, and Financial Times.
Conventional & good Advice No. 1
Continue your SIP as-is OR do nothing different from what you were doing before downturn
Dr. Bernstein says: “At a minimum, you should not sell out and panic – simply stand pat” He further goes on to say:” … when times get tough, the former (professional) stays the course, the latter (amateur) abandons the blueprints, or, more often than not, has no blueprint at all”. In an earlier article I wrote about a range of steps it takes to create a financial blueprint.
This might sound like strange advice from but it’s very valuable because at the very least it prevents you from taking any rash decisions to sell equity out of fear or panic & regretting it later. So doing nothing different from what you were doing before the downturn is very good.
I must admit that I myself have had significant trouble “doing nothing” in many situations in the context of investing in the past. I think most of us are wired to take action for success. This seems to work in many situations in life & in our careers or in in business but somehow in investing “do nothing” and taking less action seems to be the wiser choice many a time.
In particular, if you have been investing via SIPs, you just keep up with your SIP as earlier. In any case, your SIPs will buy you more mutual fund units if the markets have fallen and that’s a good thing.
Dr. Bernstein’s little known recommendation that’s better than an SIP
Switch to a “Value averaging” approach instead of an SIP
While continuing with steady SIPs is good during market downturns it doesn’t take full advantage of the opportunity at hand. This is why Dr. Bernstein recommends Value Averaging (a method developed by Harvard Professor Michael Edleson) as the BEST way for anyone to slowly & steadily build up their equity asset allocation.
Dr. Bernstein simplistically describes Value Averaging as a method which combines SIP & re-balancing. So think of it that way conceptually.
Here’s a summary of some key points on the Value Averaging approach:
- It forces you to buy more (than SIP) at market lows than at market highs (when compared to SIPs)
- It gives you a clear plan (called the “Value Path”) to follow to avoid panic selling at the bottom
- Per research by Michael Edleson, at the extreme, in a beaten down “bear” market SIP yielded 11.25% while Value averaging: yielded 25.86%
- Per research by Michael Edleson In general, Value averaging generates approx.. 1% higher absolute returns than an SIP. This may not seem like much but if we assume a long-return of 10% on equity investments, then that is effectively a 10% increase in investment.
- However, if you get lucky and you have a crash during your value averaging cycle you could make ENORMOUS gains.
If the value averaging approach sounds interesting and you want to understand it better, read my article on value averaging.
If you’d like help setting up a value path for yourself to be able to take advantage of future market downturns, feel free to reach out to me & I’ll be happy to help.
Conventional & good Advice No. 2: Re-balance to target allocation
Review your originally planned target asset allocation. In a market downturn it will likely have drifted below the target level you had set for yourself. In response, what Dr. Bernstein suggests (as do many in the investment industry) is that you buy equity to the extent that brings you back to your original target asset allocation.
Bernstein says: “…this is a technique which automatically commands you to sell when the market is euphoric and prices are high, and to buy when the market is morose and price are low”.
To illustrate re-balancing, here’s an example. Let’s say you had planned for a 50% equity & 50% debt asset allocation originally. When you review your portfolio during the downturn you find that your allocation has drifted to 45% equity and 55% debt. Then you sell det & buy equity till your equity & debt are back to 50:50
Yet again while re-balancing sounds simple, as Dr. Bernstein points out, in practice, this is not easy to do for many. This is because in effect what you are doing is selling the asset that is performing well and buying the one that is doing badly – so it’s counterintuitive for most people.
Both the above are simple & logical but many find it hard to do in practice because of the noise & panic created by the news & on social media. Cutting yourself off from the news & social media noise is the best thing you can do during a downturn. As mentioned above, a good investment advisor or coach can also help tremendously with this.
Dr. Bernstein’s little known advice that’s better than re-balancing: A rule of thumb to “overbalance”
In conventional terms, this is an investing concept called Dynamic Asset allocation.
In his book, The Four Pillars of Investing Dr. Bernstein says “You should increase your stock allocation only by very small amounts – say by 5% after a fall of 25% in prices – so as to avoid running out of cash and risking complete demoralization in the event of a 1930s style bear market.”
Revisiting the example above, let’s say you had originally planned for a 50% equity & 50% debt asset allocation originally. Let’s say the markets have fallen by 10%. So when you review your portfolio during the downturn you find that your allocation has drifted to 45% equity and 55% debt.
In the re-balancing approach, you would take it back up to 50:50. But if you were to use Bernstein’s dynamic asset allocation thumb rule, you would now INCREASE your target allocation by 2% (Bernstein recommends a 1:5 ratio so a 10% market decline warrants a 2% increase) and take your target allocation up to 52% (originally planned 50% plus 2%) instead of 50% as you would in a pure & simple re-balancing approach.
When I asked Dr. Bernstein about this a while back, he said he still believed the thumb rule applied. The only slight variation he suggested was that he would rather use a more conservative 1:10 ratio (rather than the 1:5 ratio during a downturn) if one is selling during a market bubble.
Note of caution: Dr. Bernstein recommends the above dynamic asset allocation approach ONLY for very seasoned or experienced investors.
Disclaimer: I am not a financial advisor. This article is based on Dr William Bernstein’s writings and like all my other articles purely for educational purposes. Please consult a financial advisor before making any decisions or taking any actions with regard to your investments. I shall not be liable.