The markets are getting a bit bumpy again. The U.S. stock market was down more than 5% last week and more than 3% on Friday alone. [Note: Markets are down again today, around 2% currently, making these things even more important to remember.] And people are taking notice judging by the increase in media coverage, the increased volume on financial TV, and the increasing number of people wanting to talk about what’s going on in the markets right now.
While a 3% daily drop is unusual, it isn’t exactly rare. Since 1993 there have been 69 days when the S&P 500 dropped by 3% or more, or about 3 times per year on average.
With the recent market movement in mind, here are four key things to remember about the markets and investing in stocks.
1. Things could get worse. I write this not to alarm anyone (things could also get better), but to set proper expectations. After Friday’s 3% drop, the U.S. market (SPY) is down 7.1% since its peak on July 20. World markets (ACWI) are down 8.6% over this period. According to analysis done by Adam Butler at BPG and Associates, since 1962 when the U.S. markets have seen a sell-off of 7% or more, the median final drawdown is 16%.
However, as Jason Zweig points on in his latest “Wall Street Journal” article “Stocks could drop another 10% from here, or another 25% or 50%; they could stay flat; or they could go right back up again.” The point is no one knows, and that bring us to the second thing to remember.
2. You Can’t Time the Markets. And neither can anyone else. If someone tells you they know what’s going to happen next they’re likely either lying to you, selling you something, or extremely naïve—maybe all three. Since the bull market that started in March 2009, the U.S. market has experienced pullbacks of greater than 5% on 13 different occasions. The largest of these was the nearly 20% pullback that ended in October 2011. And yet over this period, the market is up 220% — making each of these pullbacks just a blip on the radar over the six-year period. What matters for the disciplined investor is “time in the markets, not timing the markets.”
Again to quote Mr. Zweig, “After a market drop, or at any other time, no one knows what the market will do next. The one thing you can be fairly sure of is that the louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely it is that he will turn out to be wrong.”
3. Weeks like this are a big reason stocks return more than bonds. From 1928-2014, stocks compounded at 9.6% annually versus 5.0% annually for bonds. This 4.6% is difference is called the “equity risk premium.” And there are fundamental reasons for this premium: It’s compensation for stocks being lower in capital structure than bonds and as reward for being subject to both the downside and the upside of a company as an equity shareholder.
But, the feeling you have right now—that uncomfortable feeling in your gut making you wonder “is my portfolio alright?”—that’s also a big reason that stocks have returned more than bonds over time. In a very visceral way, owning stocks compared to bonds is simply more painful at times. These pullbacks happen and it’s not a whole lot of fun when you’re in the middle of one.
I think what’s important, then, is to step back and see the forest for the trees. These pullbacks (the trees) can seem pretty big and important when we are in the midst of them. But zooming out to the forest-level view, we get a sense of just how minor each individual pullback is to long-term market performance.
The chart below from my friend Michael Batnick at Ritholtz Wealth Management, paints this picture nicely. Notice how much of the time the stock market has spent in either a 5%, 10%, or 20% drawdown. And yet from 1957-2014, for those disciplined investors willing to ride out these drawdowns, the market has returned 10.2% annually—turning $1,000 investment into more than $250,000! What matters for the disciplined investor is again, “time in the markets, not timing the markets.”
4. Your Behavior Matters: Don’t pay the panic tax. We just saw that stock market investors spend a good chunk of their time in a drawdown. Therefore, to realize the ‘equity premium risk, we have to avoid buying and selling, based on fear or greed, at the wrong time. We call it the “Panic Tax” and paying this tax can have a huge impact on your returns.
According to Morningstar, for the 10 years ending in 2014, investors in U.S. equity funds lost 1% annually from their returns because of these poorly timed buy and sell decisions (International fund investors fared worse, costing themselves 1.2%). For example, in 2012, the U.S. equity fund category saw the largest net outflows (-$94 billion) and taxable bonds had the highest inflow ($270 billion). Their returns in the next year: 35% for U.S. equity versus 0.15% for bonds.
What You Can Do
Most of the time doing nothing, as boring as it sounds, really is the best action. But, it can be difficult to “not just do something; sit there” as the saying goes. So, now that we’ve gained a little perspective, taken a deep breath so to speak, you might wonder if there are any actions worth taking.
Glad you asked. Here are two.
1. Assess Your Portfolio Risk Now
If the recent market movements have you nervous, use this as a reminder to assess the riskiness of your portfolio. Instead of trying to predict when market corrections will happen, it’s better to figure out: Are you comfortable with the way your portfolio is positioned? Are you comfortable with the risk you’re taking? And are you able to stick with your strategy in a down market?
If you’re currently a client, you’ve gone through this portfolio risk assessment already. You know what to expect from your portfolio performance both in terms returns captured on the upside and the downside. However, if you would like to review again, as always please give us a call.
But chances are, if you’re not working with an advisor, assessing your portfolio risk isn’t something you’ve reviewed recently. Some people, still scared from 2008, are taking too little risk; they’re limiting their returns and therefore the potential to achieve their goals. Others, spoiled and complacent after the great run of the last six years, have too much risk in their portfolio. The risk here is panicking during a market correction, selling out, and missing any market recovery. Either way, taking too much risk or not enough is damaging to your portfolio returns—but, even more importantly, to achieving your financial goals.
So, does your portfolio have a level of risk you are comfortable with? A strategy you can stick with and that gives you confidence in achieving your goals? Now is the time to assess.
2. Determine Your Tax-Loss Harvest Strategy
Lastly, for investors with taxable assets, now is a good time to review your positions for any losses. If you have any positions at a loss, a tax-loss harvesting strategy is designed to realize any losses in your portfolio today and use these losses to reduce your current taxes.
Again, if you are client, we are doing this for you. We are reviewing your portfolio for any opportunity to reduce current taxes by tax-loss harvesting. And if you’re not a client, review your portfolio on your own for any tax harvesting opportunities you may have.
So there you have it. In periods of market stress, remember to keep the big picture in mind. No one knows exactly what will happen next, but it’s a fair bet that, like they always have, stocks will go both go up and down. Because of this it’s important your portfolio is positioned in support of your long-term goals and objectives and is designed with a level of risk you are comfortable taking.
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