Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient. (Warren Buffett)

The headline news from the financial press screams recession and the reaction of many investors is to sell stocks. To test whether this is a good strategy we will examine the returns of the S&P 500 Index during the eleven recessions from the beginning of the post-WW II era through 2007 and compare the result to the return earned on riskless one-month Treasury bills during the same periods.

During the eleven recessions—average duration of eleven months—the return of the S&P 500 Index ranged from a worst case of –17.9 percent (November 1973 through March 1975) to a best case of 27.6 percent (July 1953 through May 1954). The average return was 7.1 percent. During the same period the average return on one-month Treasury bills was 5.1 percent, 2 percent less than the return on the S&P 500 Index.

Thus, even investors that could perfectly time their exit from stocks just prior to the beginning of a recession and reentry into stocks immediately upon the ending of a recession would have failed to benefit from such a strategy. And the analysis does not take into account the costs (especially taxes) of such a timing strategy.

Investors that react to news of recessions fail to recognize that the market is actually a leading indicator of economic activity. If you could accurately forecast recessions, and there is no evidence of the ability to do so, the time to have sold stocks would be well before the recession actually begins.

Warren Buffett made the following observation in the 2004 Berkshire Hathaway Annual Shareholder Letter:

Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.

There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

As Buffett observed, reacting to the noise of the market (and the emotions that noise causes) is likely to prove to be a losing strategy. Fortunately, there is a simple strategy that allows investors to follow Buffett’s advice to be fearful when others are greedy and greedy when others are fearful. That process is called rebalancing. During bull markets (when investors tend to become greedy) you will be selling stocks to reduce your equity allocation to the appropriate level and during bear markets (when many investors are fearful) you will be buying stocks to raise your equity allocation back to the appropriate level. Of course, in order to rebalance one must first have a plan that includes an asset allocation table.

The process of rebalancing is simple. The hard part is being able to ignore the noise and the emotions that arise and actually carrying out the strategy. That is why one of my favorite expressions is that bear markets are the mechanism by which money is transferred from those with weak stomachs and no plans to those with well-thought-out plans (that anticipate bear markets) and have the discipline to stay the course.

Endnote: The eleven recessions were February 1945-October 1945, November 1948-October 1949, July 1953-May 1954, August 1957-April 1958, April 1960-February 1961, December 1969-November 1970, November 1973-March 1975, January 1980-July 1980, July 1981-November 1982, July 1990-March 1991, March 2001-November 2001. Source: BusinessWeek, February 4, 2008.)

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

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Larry Swedroe

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