01 Aug 2014 The Coming Correction
For the past several months the subject of an impending market correction has moved to the fore of media attention and investor concern. With yesterday’s stock market pull-back, more have joined the discussion.
Market corrections are the price of admission for capital market investors. How investors handle them ultimately determines how well they do over their investing careers. And sadly most investors handle corrections, even their fear of them, quite poorly.
It is important to understand that corrections are a natural occurrence in markets and they are in fact quite healthy. They rid markets of excess; when investors become more emotional than logical (irrationally exuberant or pessimistic), prices can become inflated (or deflated) well beyond the levels supported by economic and business fundamentals. Corrections are like safety valves releasing market pressures before they reach ‘bubble’ proportions. Bubbles, on the other hand, are considerably more dangerous than inflated markets because their bursting destroys not only the causes of the excesses, but also the vital bedrock of human confidence that propels an economy’s growth. Recovery of confidence and the ensuing economic prosperity can take many years, as 2008 most recently reminds us.
Think of market corrections as the pruning of fruit trees. Quite simply, though somewhat contrary to logic, a grower prunes his trees to gain more healthy fruit in the next growing season. Pruning removes dormant buds or growing points in order to invigorate the remaining buds, making them more prolific. The process removes competing branches, dead and diseased wood, and what growers call ‘suckers’ (remember the dot coms of 1999 and 2000?) allowing the tree to devote all of its nutritive energy toward more healthy growth and abundant fruit. Another vital benefit is that sun-exposed wood remains fruitful and produces the largest fruit, while shaded branches eventually stop fruiting and will never produce fruit again.
While pruning is predictable, market corrections are not, which is where so many investors lose their bearings. The idea of timing market corrections is quite appealing. We could be so much better off if we were able to escape the downs of markets and capture all of their upside. These are the thinly veiled promises made every day by active fund managers and the people who sell them. Truth is, they can’t and don’t. Take a look at a simple illustration below to see why.
The worried investor begins to feel a correction coming and he gets out of the stock market. The market continues to climb, as is most often the case with enthusiastic markets. The sidelined investor worries he is missing the upside and even considers getting back in. Then, just as he suspected, the market turns and begins a downward spiral of 5% then another 5%. Then, after some time, it turns up. Not wanting to be fooled by what is known as a ‘sucker-rally,’ our sidelined investor stays out a while longer to be sure, but eventually (when the market returns to where it was when he got out), he relents and returns.
The investor who stayed put (the horizontal blue line above) is no worse off than the investor who went to cash before the correction. In fact, one could argue, he is better off by the taxes and commission he didn’t pay to get out and back in. But more importantly, he worried considerably less during the period represented by the red line below. In reality and quite by nature, capital market investors worry more about missing growth than they do the risk of downside of their holdings during corrections. The disconnect in their thinking is caused by the belief they can correctly time their exit from and return back into the market. In essence they believe they can out-wit the collective intelligence of the entire stock market, not once but twice. As an interesting aside, check out When Entertainment Passes for Investment Advice.
Study after study bears out these truths. Investors who try to time the market invariably do worse than those who stay in, and by significant margins. Dalbar’s latest 20-year study reveals that trading investors performed nearly 4 percentage points worse than the stock funds they were in and out of between 1993 to 2012. A 4% reduction in performance over a 20-year period carries huge lifestyle impact – far worse than the relatively short-lived corrections endured along the way.
Today’s title suggests another correction is coming and it surely is. The timing of course is unknowable as Alan Greenspan wisely suggested just yesterday. He as former Fed Chair and current Fed Chair Janet Yellen and many others continue to insist that stocks are not substantially over-valued relative to historical norms – and they are not even close to bubble valuations.
A correction will certainly come in the future, because it’s what markets do. In fact, during the past 50 years, on average, equity markets dip 5% more than twice a year, 10% twice every three years, 15% once every three years, and more than 20% every five years. Volatility like that just described suggests a pretty bumpy road for our financial journey, and bumpy it is if we take more risk (hold a higher allocation of stocks) than we are able to stomach.
We believe the best approach to investing is to develop a clear plan of the things you want to accomplish with your investments and take no more risk than is necessary to confidently achieve them. It sounds simple and for our clients, it is. But a great deal of work goes on behind the scenes to ensure that our clients will confidently meet or exceed every goal they value. That work includes placing them in portfolios that deliver no more risk or bumpiness than is necessary to meet their goals. Note the difference. We do not subject our clients to a level of bumpiness they believe they can tolerate which is often considerably higher – that is until we have days like yesterday when the overly aggressive can turn overly conservative.
With the knowledge that their risk is proportional to their plan’s requirements, and their portfolio is designed to absorb the stock market’s shocks better than any other design we know, and that we continually reevaluate the confidence of meeting and exceeding their goals, our clients worry considerably less than those who use the stock market to plan their future.