The first stock market correction in nearly four years (in 2011, the S&P 500 sank by nearly 20 percent) has been a great reminder to investors of core concepts that can guide us through both good and bad times. First a note about this correction: it was long overdue. In statistics dating back to 1900 for the Dow Jones Industrial, here is the average frequency and duration for stock market sell offs:
- A decline of 5% or more has occurred about 3 times per year on average, and lasted on average about 46 days.
- A decline of 10% or more has occurred about once a year on average, and lasted on average about 115 days.
- A decline of 15% or more has occurred about once every 2 years on average, and lasted on average about 216 days.
- A decline of 20% or more has occurred about every 3.5 years on average, and lasted on average about 338 days.
Despite being a normal part of the investment cycle, these are trying times, which demand 5 simple investor action items. Here goes:
1. Keep Cool, Sit Still and Do Nothing! There are two emotions that influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed. To guard against this cycle, try not to do anything amid these volatile trading sessions. Consider this: If you had sold all of your stocks during the first week of the financial crisis in September 2008, you would have been shielded from another 40+ percent in further losses (stocks bottomed out in March 2009). But how would you have known when to get back in? Most investors, from seasoned pros to mere mortals who are saving for retirement, lack the guts or lucky timing to buy when stock indexes seem like they are hurtling towards zero! As a result, even if you made a decent sale in the fall of 2008, you most likely would not have bought the rock bottom in March 2009 and you may have missed the near tripling in value of the indexes from the lows.
2. Remember: You are wired to fail. Human emotions can mess with your investment returns. Benjamin Graham, the founder of security analysis, said in his 1949 masterpiece, The Intelligent Investor. “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Research proves the point: According to Dalbar’s 21st Quantitative Analysis Of Investor Behavior study, the 20-year annualized return (through 2014) for the average equity mutual fund investor was 5.19 percent, compared to the 20-year annualized S&P return of 9.85 percent. Investors lagged the index by a whopping 4.66 percent annually!
Dalbar says the biggest reason for underperformance is psychology, highlighted by investor panic selling at the bottom, as well as the lure of following short-term market trends. Guard against these big emotional pulls by reminding yourself that just because you feel something, does not mean you need to do anything!
3. Adhere to a diversified portfolio…and don’t forget to rebalance. One of the best ways to prevent emotional swings is to create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities.
Prior to this sell off, the most frequent investment question I fielded on my radio show was “Should I dump my bonds?” I sure hope that you didn’t, because as the stock market has been sinking, those bonds were like a life vest to your portfolio. But that’s the rub with asset allocation: you have to live with certain parts of your portfolio underperforming at times, in order to reap the payback that occurs when market events turn the previous dogs into champions.
4. Maintain a healthy emergency reserve fund. Bad luck can occur at any time. One great lesson of the Great Recession was that those who had ample emergency reserve funds (6 to 12 months of expenses for those who were employed and 12 to 24 months for those who were retired) had many more choices than those who did not. While a large cash cushion seems like a waste to some (“it’s not earning anything!”), it allows people to refrain from selling assets at the wrong time and/or from invading retirement accounts.
5. Understand what is in your target date fund: Over the past ten years or so, many investors have been flocking to mutual funds in which the fund manager “targets” your future date of retirement an adjusts the asset allocation as you near the time that you will need to access the money. Unfortunately, many of these funds are far riskier than investors understand. Whether it’s a target date fund or an age-based investment for your kid’s college fund, be sure to check out the risk level before you put a dollar to work.