The Witch of October is here: Remember, short-term pain = long-term progress

The month of October strikes fear into the hearts of many Wall Street veterans – and for good reason. Over the past 123 years, seven of the ten worst days in U.S. stock market history occurred during this seemingly turbulent 31-day period.

But there’s nothing supernatural about these October horrors: they’re remnants of the nineteenth century Agricultural financing cycle. In the 18th century, farmers harvested their crops and took them to market in the autumn, paying for the operation with large withdrawals from their local banks. These banks, in turn, withdrew funds from larger New York banks and trusts to replenish their reserves, making Wall Street financial markets particularly vulnerable to panics. Even after the United States transitioned to an industrial economy and reestablished a central bank system within the early twentieth century, memories of Octobers past appear to have caused investors to panic out of habit. October 2022 may very well be just the most recent manifestation.

Cost of Closet Tactical Asset Allocation

Panic is the mortal enemy of long-term investors, especially in volatile markets, but that does not imply we must always sit idly by within the face of one other scare in October. In times like these, the remark of the late David Swensen in his classic is value remembering:

“Perhaps the most common variant of market timing is not in the form of explicit bets for and against asset classes, but rather in the form of a passive deviation from the target allocation.”

Many investors don’t heed this recommendation right when it’s most useful. Instead, they let their profits flow during bull markets after which freeze when markets slide into bear territory. This is precisely the insidious type of tactical asset allocation that Swensen is referring to.

But history shows that this is rarely smart. For every scholar who successfully navigates the treacherous macroeconomic currents, many more suffer financial disaster while making the attempt. Failure to rebalance is probably not ruinous, but it should almost definitely reduce long-term returns.

Dow Jones Industrial Average: 10 worst trading days:

Why is such tactical asset allocation so common amongst pension funds, endowments, foundations, and other institutional investors? Because many are advised by non-discretionary investment advisors who lack the authority to rebalance portfolios, they simply fail to advise their clients to achieve this. But trustees must take the initiative and ensure they implement the realignment at times like these.

Short term pain and long run gain

In Ray Dalio advises readers to hunt painful feedback in order that they can confront their shortcomings and gain the insights needed to eliminate them. He often repeats the mantra: pain + reflection = progress. Economic events follow an analogous principle. Today’s economic problems are more likely to worsen in the approaching months, but that does not imply we’re suffering unnecessarily. The mistakes of the past have to be corrected. Higher inflation has persevered for too long and restoring price stability is important to securing future economic prosperity. We learned this within the Nineteen Eighties. There is not any must learn it again within the 2020s. We should stop inflation, and while it should be painful, it should be value it.

Today’s hardships won’t be in vain. After the recession of 1981 and 1982 subsided, the U.S. economy got here back stronger. Driven by extraordinary technological innovations, the country experienced twenty years of economic prosperity.

There has been a variety of financial anxiety over the past two and a half years. We may even see more this October and in the approaching months. But when it’s over, we’ll breathe freely again. In the meantime, we must steel our nerves, rebalance our portfolios, and trust that the pain we endure now can be rewarded in the long run.

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Photo credit: ©Getty Images/Đorđe Milutinović