Under ordinary circumstances, how should individual investors respond to sharp downturns in the stock market?

The conventional “smart” wisdom is that only naive investors sell their stock holdings when the market tanks. Warren Buffett once advocated being “fearful when others are greedy and greedy when others are fearful.” In other words, market downturns are when investment opportunities are the most attractive, so you shouldn’t sell when the market crashes.

My thinking on this has been changed by a paper by my former Yale SOM colleagues Alan Moreira and Tyler Muir, “Volatility-Managed Portfolios.” Sharp market drops are accompanied by sharp increases in market volatility, and volatility remains predictably high for a short period afterwards. Puzzlingly, average returns on stocks do not increase much, if at all, during times of predictably high volatility. So the expected compensation you get for bearing a unit of risk is unusually low right after a market crash.

This means that you can get better risk-adjusted returns if you scale back your stock market position when volatility spikes, but then are quick to jump back in when volatility settles down. (The half-life of volatility spikes is about five months.)

A recent paper by Scott Cederburg and his co-authors has highlighted that it is difficult for an actual investor to profit from the above trading strategy because of instability in the relationship between recent volatility and future returns, so it should be regarded with caution. Nonetheless, I think that for extreme volatility spikes like we have experienced during the COVID-19 crisis, it is reasonable for smart investors to scale back their stock positions.

How does the nature of this crisis change your advice?

I don’t think we have any information about this crisis that would indicate that it is different from other crises from an investment standpoint. It is important to keep in mind that this crisis, painful as it is in the short term, is unlikely to have catastrophic long-term economic effects. The 1918 Spanish flu was much more devastating economically because it struck down people of prime working age, whereas the data on COVID-19 indicate that mortality is heavily concentrated among the elderly. The U.S. stock market did quite well in 1918 and 1919.

The pure economic damage from COVID-19 (not counting the human cost of lives lost) comes largely from the cessation of economic activity due to attempts to slow its spread. Suppose this caused aggregate corporate profits to fall to 0 for the next two years before they return to last year’s levels. (Keep in mind that U.S. corporate profits did not fall to 0 even in 2008 or 2009.) With a 10% discount rate on profits, this should cause the stock market to fall by only 17%. With a 5% discount rate on profits, the drop in value is only 9%.

Is your advice different for those who are approaching retirement?

Those who are close to retirement should at baseline have more conservative investment portfolios. It wouldn’t be unreasonable for such folks to temporarily drop their stock allocations to 0. Younger investors should have more aggressive investment portfolios; standard academic models suggest that financial portfolios should ordinarily be 100% stock well into one’s 40s. (The typical portfolio advice given by the financial industry is much more conservative than what academic models recommend.) Although younger investors can consider scaling back their stock positions, I would caution against taking those positions all the way down to 0. Studies across many different domains indicate that predictive models that recommend extreme adjustments do rather poorly on average because the future is really hard to predict with much accuracy.

This article is based on academic research and is not individual investment advice. Consult your financial advisor about your portfolio.