We knew that a stock market correction was coming, but why then did everyone seem so shocked when it arrived on Februarys 8th? Corrections, defined as 10 percent drops from the recent highs (January 26th), usually occur every year or so. Until last week, it had been two full years since the major US indexes had corrected. In other words, we were overdue for a drop.
The spark for this particular move down was a combination of things. The best explanation is that there was a fear of inflation and the potential for more Federal Reserve (and other global central bank) interest rate increases this year amid a period when stock prices had gotten ahead of company earnings (this is what is known as “high valuations”). The accelerant to the move down was attributed to an unwinding of a trade that professional investors made betting against volatility as well as what we old timers used to call program trading, but is now known as algorithmic trading.
Regardless of the why, it is important to cheer for this much needed market breather because it reminds us to acknowledge that investing is risky. The problem with periods of relative calm that we had seen prior to this correction is that they can give us a case of investor amnesia. The condition may temporarily allow us to tune out the potential for losses and allow us to pile into stocks because they have been rising or let our allocation get out of whack because “everything is doing so well”. For that reason alone, I cherish the lesson of a nasty correction because it is a prompt to ask ourselves why we are investing in the first place.
So what should you do now?
I’m freaked out and can’t sleep: You probably came into this period with too much risk. If that’s the case, you may need to readjust your allocation. If you do make changes, do NOT jump back into those riskier holdings after markets stabilize. You need to make a pinky swear with yourself that you will stick to your revised plan -- FOR REAL!
I need cash from my account within the next 12 months: Whether it’s a house down payment, a car purchase or a tuition bill, that money should never have been be at risk at all, so admit that you blew it and get whatever you need out of the stock or even the bond market.
I don’t need the money for at least five years, but I’m still nervous: DO NOTHING. You should feel butterflies, because these gyrations are totally out of your control. But that does not mean that you should alter your game plan. Although you may be tempted to sell or halt your contributions into stock funds in your retirement or college funding plan, you do so at your own peril. Even if you manage to steer clear of continued drops in the market by staying in cash, you are unlikely to get back in at the bottom. This is called market timing and it is nearly impossible to do consistently over the long term.
Additionally, if you are not investing on the way down, you will not be able to reinvest dividends and fixed-income payments at the bottom.
The best way to avoid falling into the trap of letting your emotions dictate investment decisions is to adhere to a diversified portfolio strategy, based on your goals, risk tolerance and time horizon. It may sound simple, but over the long term, it works. It’s tough to do, but sometimes the best action is NO ACTION.