Market Volatility: When to be afraid

Have your nerves been on edge because of recent swings in the stock market? When @Hatton1, a popular WCI forum participant, started a thread on 2/3/18 titled I congratulate the forum, she was giving everyone a big high-5 for not panicking over the 1,100 point drop in the Dow the day before.

But subsequent volatility gave the thread a life of its own, leading to a discussion of market timing opportunities. Was it a good time to buy? Tax-loss harvest? Take some “money off the table”? Were the legs of the long bull finally giving out?

This turned into a very interesting discussion. When I comment on the forum, it’s with an eye to the thousands of “lurkers” – readers who remain anonymous but are impacted by many of our discussions. So, this post is for you investors, mostly young, who have not yet had the distinct pleasure of watching your portfolio drop 20%-50% in a bear market. Since starting medical school, your experiences in the stock market have all been positive. And you probably didn’t pay much attention to the last bear because you were finishing up high school or in college.

Now that you’re an attending and fully participating in your employer’s retirement plan, it’s not theoretical any more – this is your retirement kitty at stake! So perhaps your perspective has been altered. But should it be? Let’s look at history.

  • Since the “Great Depression (1929), a basket of equities (stocks) has increased in value an average of 10% (large cap stocks) to 12% (small cap stocks) annually, with dividends reinvested.
  • Since the end of WWII, we have experienced bear markets (a drop of 20%) every 5.5 years, on average.
  • On average, the market drops 14.3% on an intra-year basis.

Since the last bear market in 2008-2009, market growth has surpassed the 10%/12% long-term average annual returns (except for 2015). With a couple of exceptions (Brexit, for one), we have not experienced normal intra-year drops. As a result, many investors have become complacent but the volatility of the last few weeks has been perfectly normal. The growth of the past 10 years may have seemed like a “new normal” but, when viewed over the long term, we’ve been recovering from the last bear market and the economy has been expanding.

So… should I be afraid?

As I said, the market has averaged 10% – 12% annual growth – over the long term. But all portfolios are not equal. If you are one of these three kinds of investors, you should be afraid:

  1. You do not have a well-diversified equity portfolio. Long-term returns are calculated based on a diversified market basket of stocks, not on one sector or another. An example I often use is the technology crash in year 2000. Many investors were 100% equity – but all in one sector (technology) and they never recovered. There were others who allocated only a small part of their portfolios to technology, and kept a well-diversified portfolio, with no long-term adverse effects.
  2. You are a stock-picker. The best and most common example of stock picking is the clients who have a large part of their portfolio in employer stocks. If you are counting on this stock to support you in retirement, you are making a dangerous bet and should allocate no more than 10% of your portfolio to company stock. Mutual funds and ETFs ensure that you will never have enough of any one stock to get killed. If you want to gamble, do it in Las Vegas – at least you’ll get free drinks.
  3. You invest for the short term. You may have a well-diversified portfolio that is invested in equity funds, but have no plan in place for when you’ll need your money. This leaves you susceptible to panic when the market nosedives and leads to irrational behavior such as a sudden fondness for bond funds. The short term market is volatile and unpredictable – a real gamble – but returns smooth into an upward trend line over the long term. How do you know how much you need in the short term and how much you can invest for the long term? You follow a personal financial plan.

Fortunately, all of the above are easily correctable and you can stop being afraid once you implement a plan and rebalance into a properly-diversified equity portfolio. You do not “lose” money when the market is down, just as you don’t “make” money when the market goes up. The only way you lose money is to sell at a loss. The only way to make money is to sell at a profit. Until then, build a proper portfolio, follow your plan, and ignore everyone else’s fear about the market.

By the way, our clients did not panic – not one! – during the recent market volatility. This tells us you have taken the lessons of Simple Wealth, Inevitable Wealth to heart. We can’t begin to tell you how much we admire you for doing so. But what about those who asked if now is a good time to put money in the market? Michelle has made a great video to answer your question.

And just in case you’re wondering what to do with all of that money you’re going to take out of the stock market, this month’s Doctor Dilemma is an update on a favorite, When Low Interest Rates Are OK

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