“With the stock market at an all-time high, a devastating correction is imminent.” This is a common warning these days that has some people nervous about their investments. We have our own warning – don’t be distracted by prognosticators.
Stock market corrections are not more likely at market highs. The frequency of declines in the U.S. stock market after the market reaches an all-time high is virtually identical to the frequency of declines after any other period.[i] This does not mean a correction will not occur. Stock market corrections and “bear markets” are quite common. So common, that experiencing them should be expected as a normal part of being a long term investor, not something to hope will not happen. So, it’s best not to worry about whether the bear is going to growl, because growl it will and often. That is the nature of the beast.
Stock market corrections and “bear markets” are quite common. So common, that experiencing them should be expected as a normal part of being a long term investor, not something to hope will not happen.
According to Yardeni Research, since 1928 the S&P 500 index has experienced 46 corrections, defined as a decline of 10% or more. That’s more frequent than once every other year. In 20 of those cases, more than once every five years on average, the decline was over 20%. The longest stretch between market corrections was just eight years.
But, what if the market is heading toward a correction? Will a stock market correction be devastating?
In our view, if your life will be devastated by a market correction, you have a lousy plan. A market correction should be inconsequential and a bear market should be something you can weather.
Why Good Plans Can Make Stock Market Corrections Inconsequential
First, a portfolio should be designed with your goals and time horizon in mind. With the stock market gyrating dramatically on an ongoing basis, your short term needs should not be dependent on the behavior of stocks. For most people, this means they should not have all their money in stocks. As such, a 10% stock market correction will likely result in a drop in portfolio value of less than 10%.
Second, a good plan expects the gyrations of the market. It is astounding how many people put money in stocks and then are shocked, shocked we tell you, when stocks drop in value. These folks were either unaware of how the market behaves, believed their research uncovered holdings that were somehow immune, or thought they could get out before a decline.
Third, good planning recognizes risk comes in many forms and is unavoidable. Therefore, the focus is on managing risk rather than wishing it didn’t exist. For instance, stocks have been terrific when used to earn a return in excess of inflation over long periods of time. Stocks are not good at maintaining a steady value. Good plans never forget this contradiction and use stocks to fund long term goals, not short term needs.
You Can Succeed Without Depending on Predictions
Consider the hypothetical balanced investor that owns a simple mix of 60% in stocks (represented by the S&P 500) and 40% in 1-month treasury bills, rebalanced annually[ii]. Such an investor makes no attempt at predicting market movements and does not try to maneuver in and out of the market based on predictions. Historically, such an approach has been quite resilient.
Using monthly data through June 2014, the S&P 500 provides 1,062 months between January 1926 and June of 2004 that one could have started a ten year period of investing. Of those 1,062 months, we identified 99 months in which one could have begun a ten year period with the S&P 500 losing 10% or more in the first six months. In only five of those 99 unfortunately timed start dates, all between September 1929 and June of 1930, did the hypothetical balanced portfolio lose value over ten years.
The worst result was a annualized loss of just 1.14% for the ten years starting in September of 1929. That is also the only loss of more than 1% per year. Keep in mind there were significant additional declines past the infamous September 1929 crash that kicked off the Great Depression. The S&P 500 index dropped nearly 83% in total over 33 months from September of 1929 through June of 1932. Nonetheless, the average result for the other 94 periods that started with a correction after June 1930 was 6%.
Is Timing the Market Really That Difficult?
It is highly unlikely that one will predict stock market corrections with enough accuracy over an investing lifetime to produce a good result after costs. First, you must sell and incur the costs of selling, including taxes.
Second, the market must decline fast enough and far enough below your selling price to make up for the costs. If after the sale the market instead rises, the higher it rises, the more severe the correction must be to provide profit potential from the timing maneuver.
Lastly, you have to buy when the market is down and then hold on for a long enough period of time for the market to rise and before you get nervous and want to sell for fear of the next correction. Remember, the premise that started this discussion was that when the market goes up, a 10% drop in the stock market is likely and such a drop in value would be a problem requiring evasive action.
Taking into account all these factors and the chances of timing market buys and sells accurately enough several times during one’s investing lifetime are slim. The odds are bleak because of the simple fact that stocks have gone up more often than they have gone down. Whether it is better to be in or out has not been a 50/50 proposition.
If you had a coin that came up heads in 51% of tosses, the smartest, most reliable way to win would be to bet a consistent amount on heads over and over again. Any given flip could be tails, and tails would come up often, but the more bets you made on heads, the more likely you would come out ahead – as long as you didn’t fight the odds. Markets rise more often than they fall. Staying invested over the long term is like betting heads every month but with a better than 60% probability. The chart shows how the strategy has played out.[iii]
Earlier we stated, “A correction should be inconsequential and a bear market should be something you can weather.” Reflect on your own experience and you should now be confident in this truth. If you had a good plan and stayed with it, your life has not been devastated because of the stock market. In the last 15 years, you weathered two of the worst bear markets since the depression (burst bubbles in tech stocks and real estate). Heck, just in the last five years you have experienced three corrections. Done right, buy and hold doesn’t mean buy and ignore.
No one likes it when stock market corrections come, but prudent investors know that making decisions with the long term in mind has always proved wise, even if it did not immediately alleviate the short term pain. As often as corrections occur, it is a near certainty that the portfolios of long term investors with any stock holdings will lose value periodically.
Corrections of all magnitudes ended and reversed themselves. All of them. No one knows what the future holds, but this is an encouraging track record.
Ignore the Media Pundits
When the next stock market correction comes, whether it is soon or after additional gains, you should be more inclined to buy a little more stock, not sell. This may not be easy. Almost daily, the media will tell you, “Be afraid of stocks.” As the media has done in all previous corrections, the farther stocks fall, the louder the “be afraid” refrain will be.
Remember, the financial media is not there to help you make prudent decisions about your money. They exist to sell ads. They know nothing about you, your family, your dreams, your resources, your constraints, your temperament, your tax profile, or your plans.
As a prudent long term investor, they aren’t even talking to you. They are addressing people who have put themselves in the precarious position of needing to predict the unpredictable. Ignore them. Ignoring all their prior calls of doom has been sensible, so chances are ignoring them the next time will also be sensible.
Focus on what you can control. Ignore the noise. Invest, don’t speculate.
If you have any questions or would like to discuss this further, please give us a call or send us a note.
If you are not a client and you wish to receive emails notifications of new posts – no more than monthly – fill out the subscription information in the sidebar to the right. For more frequent updates, subscribe via RSS feed or follow us on Google+, LinkedIn, or Twitter
[i] Study by Dimensional Fund Advisors, 2013
[ii] For illustrative purposes only. You can not invest directly in an index. Returns are gross and investors that try to replicate the hypothetical portfolio described will incur costs not reflected.
[iii] Data from Center for Research in Securities Pricing, University of Chicago
Moisand Fitzgerald Tamayo, LLC is an Orlando, FL and Melbourne, FL based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between.
If you have any questions or would like to discuss anything further, please give us a call or send us a note.
If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right.
Important Additional Information & Disclosures
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Moisand Fitzgerald Tamayo, LLC-“MFT”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from MFT.
Please remember that if you are a MFT client, it remains your responsibility to advise MFT, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MFT is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. Tax advice is given only to clients and only when agreed to by MFT. A copy of the MFT’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.
Please Note: MFT does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to MFT’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
Please Note: Limitations: While MFT does NOT pay for recognition, awards, or publicity, neither rankings and/or recognition by unaffiliated rating services, publications, or other organizations, nor the achievement of any designation or certification, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if MFT is engaged, or continues to be engaged, to provide investment advisory services. Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Rankings are generally limited to participating advisers. No ranking or recognition should be construed as a current or past endorsement of MFT by any of its clients. ANY QUESTIONS: MFT’s Chief Compliance Officer remains available to address any questions regarding rankings and/or recognitions, including providing the criteria used for any reflected ranking.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your MFT account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your MFT accounts; and, (3) a description of each comparative benchmark/index is available upon request.