Eight Principles to Focus On

By: Sam Swift, CFA, CFP®

In times of significant stock market declines, it’s good to step back and remember a few key principles.

This is normal

Over the past century, U.S. stock markets have experienced a drop of 10% about once per year on average. They experienced a drop of 20% about every three and a half years. Despite this, they have produced annualized returns near 10% over their history.

The past is obvious, but the future isn’t

There’s an entire field of finance dedicated to investor behavior that has essentially concluded we’re irrational. One of the main problems behavioral finance has identified is hindsight bias. That is, past events always seem to have been predictable and certain after the fact—of course tech stocks were way overvalued in the late 90’s…of course the housing market was overheated in 2007…obviously the collapse of Lehman was going to lead to the biggest drop since the Great Depression. Though the revisionist history makes us feel dumb for not taking action, the truth is that these explanations were not obvious in real time. Just look at the following chart from last year:

There’s little correlation between current events and market movements. The current drop could be because there are fears about China or low oil prices (who would have guessed that low energy prices are now a negative thing for the market?!), but it could also be because many investors needed to liquidate some cash for taxes. We don’t know for sure. The only real explanation for any market drop is that there were more sellers than buyers.

There are always reasons to fear a market drop…

The risk that your portfolio can experience significant short-term drops in value is the reason we expect significantly positive long-term returns! If the ride was easy, we wouldn’t get paid.

…but markets are resilient

Your instincts are your worst enemy when it comes to investing

It seems crazy to our reptilian brain to do nothing when our account values are getting smaller and smaller—EMERGENCY! EMERGENCY! AVOID DANGER! It’s how we’re wired.

Unfortunately, our instincts don’t kick in to tell us we’re in danger at the right time when it comes to investing. Our reaction to hide often comes after the threat has run its course. Nobody wants to sell while the market is peaking, but everyone wants to sell after it’s already dropped 10% or 20%. If you stop to think about it though, you’ve likely experienced a significant portion of the drop already –the average bear market lasts for fifteen months and drops 25%. By bailing after a slump, your risk of missing a rapid upswing outweighs your risk of avoiding further losses.

Timing the market is nearly impossible and will likely derail your plan

“The stock market is designed to transfer money from the active to the patient.”—Warren Buffett

It’s easy to think you could just sell and sit on the sidelines until things cool down—you’re not market timing, you may think, but just taking a breather. Ben Casselman at fivethirtyeight.com looked at a scenario comparing a buy and hold investor to one who would “play it safe”—that is, sell any time the market lost five percent in a week, but buy back in once the market had rebounded three percent from wherever it bottomed out. With hindsight, that’s pretty effective timing. Here are the results:

This would have caused significant harm to someone’s overall wealth over a 35 year period—they end up with only half what they otherwise would have.

Positive market returns happen quickly and randomly

The following chart shows the impact of missing just a few days of positive market returns.

That’s right, if you missed just the 25 best days of the last 45 years, you end up with only about one fourth of the wealth you otherwise would have had. The only way to make sure you don’t miss those days is to stay invested.

Most importantly, you have a plan

The money you have invested in the stock market is money you shouldn’t need for a minimum of five years. For the money you do need in the next five years, you should have a significant amount invested in short-term, high-quality fixed income that will remain relatively stable and be able to fund your lifestyle while stocks inevitably recover. Any good plan factors in unavoidable market drops and is structured such that your life will not be derailed by them. Nick Murray is a respected financial advisor and author and sums it up best:

“All financial success comes from acting on a plan. A lot of financial failure comes from reacting to the market.”