The last few weeks have been rough for the markets. As we write this on Monday morning, the Dow Jones Industrial Average has been down over a thousand points. Who knows where it will be when this email hits your mailbox later in the day. With so much volatility out there, we wanted to offer a few thoughts to try and put it all in perspective.
Corrections will always be nerve-wracking but they are not something to be feared.
In order for financial markets to work properly and give you the potential for long-term gains in stocks, they must occasionally go down. Sometimes we see a 100 point drop in the Dow and other times we see the 5.7% pullback we saw last week. If stocks didn’t go down, there would be no risk and no potential for gains. All investments would be like holding cash.
The occasional upset stomach is the price we pay for trying to outpace inflation.
The big question many of us ask is “why is this happening now?” Some of the current reasons quoted are: the slowing Chinese economy, the drop in energyprices, a possible increase in interest rates and weakness in commodities.
These may all be partial factors but in our opinion, markets were probably just too frothy. Since we can’t know the future, all we can do is analyze the probabilities and the probability is that we are experiencing a long-overdue and healthy correction. We won’t be surprised to see this correction overshoot a bit. It’s common for markets to do so on the upside and downside. In short, there are simply more sellers than buyers and we should acknowledge that markets may work their way lower before stabilizing.
A few months ago, we sent an issue of Worth Considering noting that it had been quite some time since we had seen a 10% correction. Well, now we have one. Market corrections are, of course, quite common in history but that fact doesn’t make us feel good when they happen. It’s been shown that a drop in our portfolios makes us feel at least twice as bad as an equal amount of appreciation. Logically, it should be the same but that’s not how we’re wired. As such, our investment biases are our biggest enemy in a down market.
We’re not here to say that the volatility is gone and markets will resume their upward trend very soon. This period could last for a while or it could be short-lived. Nobody knows what will happen.
What we can say is that wholesale panic selling in these situations seldom works in the long term. Many people will tell themselves that they’ll sell it all now and just buy back in when things get better. The major problem with this logic is that major gains are often made in a small amount of days and if you miss those few best days in any year, you are most likely to have poor overall performance. Those good days often happen around a lot of noise and by time you realize the correction is over, it’s probably going to be too late.
This doesn’t mean that we don’t look to raise some cash in areas that now look to be more vulnerable than before. We are fine with going from a 10% to a 15% or 20% cash position by lightening up on certain positions but a wholesale move to cash is probably not the best idea for most people.
The probability is that we have nothing more than a correction on our hands but we accept the distinct possibility that we might see a new trend of lower stock prices developing. If that happens to be the case we’ll look to keep risks in line primarily with the continued use of stop loss* orders.
The use of stop losses* is one good way to eliminate market timing tendencies. They allow for the recognition that nobody will ever be able to accurately guess the top or bottom of any asset’s price and they also allow prices to fluctuate from time to time without chasing capital to the sidelines when volatility comes along.
The Wall Street Journal had a nice little piece on Friday afternoon titled “5 Things Investors Shouldn’t Do Now.” The Author, Jason Zweig, listed these about how not to react:
- Don’t fixate on the news.
- Don’t panic.
- Don’t be complacent.
- Don’t get hung up on the talk of a “correction.”
- Don’t think you—or anyone else—knows what will happen next.
Point #3 about complacency is probably the most important in our opinion. A market like this puts our investment attitudes to the test. Are we actually going to follow our plan or are we going to change it in a knee-jerk reaction to a market pullback?
In addition to the points made above, we have a few other thoughts to share from our own experiences in this business over the past few decades:
- We would reiterate that successful investors are able to contain their emotions and make rational decisions while others panic around them. Warren Buffet is famous for suggesting that investors be fearful when others are greedy and greedy when others are fearful. This is extremely challenging. It might be more realistic to suggest that investors just try to focus on their own long-term needs and do their best to pay little attention to the fear and greed levels of others.
- Successful investors don’t force the issue; they accept the current reality for what it is. If the light isn’t green, they don’t just make up their own rules and plow ahead. That’s very dangerous. It’s the same with allocating assets; don’t try to move lower down the quality spectrum by trying to achieve an unrealistic return with riskier assets.
- It’s also important to take an accurate assessment of what you need from your investments, not what you want from them. Sure, we all want consistently positive and outrageously high returns but it is vital to allocate based on your specific needs. Allocating to “beat the market” or “make more than my buddies” is the stuff that leads to danger.
Many people reading this have been through these corrections with us and you may note that we try to deliver a consistent message every time. These pullbacks are essential for markets to function properly and hopefully we’ll soon be able to pick up some bargains and/or reallocate to better values.
Asset allocation continues to be one of the few long-term strategies for getting through these periods. It’s not a panacea and it may not work over a 1 week period but multitudes of studies and real world experience have demonstrated to us that it works over a longer period of time.
And just like we’ve done in the past, we stand here ready to help you in any way possible. Do not hesitate to contact Tara Tucker at firstname.lastname@example.org to set up a time to speak with us. We will do whatever we need to help you feel comfortable with your portfolio/financial plan and help you achieve your financial goals.
We are committed to seeking out the most effective ways to allocate our client’s assets. This includes strategies that not only aim to take advantage of positive trends in the markets, but also to mitigate the risks that come along with the territory. Whenever possible, we will do our best to clearly communicate our expectations as well as our intentions for how to address the unknown.
We fully appreciate the uneasy feelings that come along with market corrections and we realize the shadows of 2001 and 2008 stretch a long way. We would be more than happy to have a detailed discussion about not just the here and now of the markets, but also about the bigger picture of your financial peace of mind.
Jeff and Ken
P.S. There’s no doubt you’ll be getting emails from pundits claiming to have predicted this correction. If you say, year after year, that a major market drop is coming, you are going to be correct at some point and we guarantee you that the marketing departments of these pundits know this. Now will be their time to shine and, more importantly, collect subscription fees. What they won’t tell you is how much money was lost while sitting on the sidelines as markets went up. If you get these emails, feel free to forward them to us. We like to keep up on these things.
*A triggered Stop Loss Order does not guarantee that your sale order will be filled. In a rapid market the limit price of your order may be higher than the market price being offered when your order is placed into the market. This may mean your order will not be traded at the price you have set. This disclosure does not disclose all the risks associated with the use of a Stop Loss Order and should not be relied upon as a complete explanation of the risks involved with using Stop Loss Orders. If you need further explanation of the risks associated with the use of Stop Loss Orders, you should seek appropriate profession advice. While the intention of a Stop Loss Order is to limit losses to a certain amount, an order may not always be effective because market conditions may make it impossible to execute a particular instruction.
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