We’ve Experienced a Market “Correction,” Now What Should We Do?

Clients who regularly follow the stock market (and even those who don’t) have likely observed the significant decline in stock prices that has been ringing in this new year.  Market indices such as the S&P 500 have dropped over 10% in the past 3 weeks.  Economists generally describe a decline in stock indices of 10% or more as a “market correction,” and this recent decline is the second market correction that we have experienced in the past 5 months.  The first took place in late August, largely fueled by concerns about the Chinese economy and its potential for negatively impacting the global economy.  Clearly, watching your portfolio nosedive is no fun for anyone (not the least of which, your financial advisor!) and could truly impact the lifestyle of those who need to sell equities during a decline, e.g. those in retirement whose portfolios do not include a sufficient stash of cash and bonds.  However, as unpleasant as such declines might be, patience is still the name of the game.  Any attempts to “manage” the correction by timing the market would be ill-advised, given the strong possibility of missing out on some or all of the subsequent recovery.  And while past performance is not a guarantee of future returns, the rebounds after past market corrections do give plenty of reason for optimism, as discussed below.

Weston Wellington, Vice President of Dimensional Fund Advisors, wrote the following article in the wake of the market correction in August, and his observations and advice are equally applicable now.  The article will hopefully aid in demonstrating the risk of selling stocks in response to the fear that often accompanies a market correction.  But, as always, call us with any concerns.  That’s what we’re here for.

    September 15, 2015

  Should Investors Sell After a “Correction”?

   Weston Wellington

     Vice President

Stock prices in markets around the world fluctuated dramatically for the week ended August 27. Based on closing prices, the S&P 500 Index declined 12.35% from its record high of 2130.82 on May 21 through August 24. Financial professionals generally describe any decline of 10% or more from a previous peak as a “correction,” although it is unclear what investors should do with this information. Should they seek to protect themselves from further declines by selling, or should they consider it an opportunity to purchase stocks at more favorable prices?

Based on S&P 500 data, stock prices have declined 10% or more on 28 occasions between January 1926 and June 2015. Obviously, every decline of 20% or 30% or 40% began with a decline of 10%. As a result, some investors believe that avoiding large losses can be accomplished easily by eliminating equity exposure entirely once the 10% threshold has been breached.

Market timing is a seductive strategy. If we could sell stocks prior to a substantial decline and hold cash instead, our long-run returns could be exponentially higher. But successful market timing is a two-step process: determining when to sell stocks and when to buy them back. Avoiding short-term losses runs the risk of avoiding even larger long-term gains. Regardless of whether stock prices have advanced 10% or declined 10% from a previous level, they always reflect (1) the collective assessment of the future by millions of market participants and (2) the expectation that equities in both the US and markets around the world have positive expected returns.

Exhibit 1 below shows that US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar.

Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly. The world is an uncertain place. The role of securities markets is to reflect new developments– both positive and negative–in security prices as quickly as possible. Investors who accept dramatic price fluctuations as a characteristic of liquid markets may have a distinct advantage over those who are easily frightened or confused by day-to-day events and are more likely to achieve long-run investing success.