We’ve had a rough start to 2016, with stocks dropping across the board. Today, we are within a couple of percentage points of retesting the lows of last August. You can’t pick up a newspaper or tune into a business show on TV without being bombarded with the “reasons” why the market is down.
The key to success for investors, I would argue, is not in understanding the economy, interest rates, or corporate earnings. Rather, it is knowing what to do in volatile times.
There are two types of losses: a temporary drop and a permanent loss. Enron was a permanent loss. Single securities (stocks or bonds) can go to zero, and this does happen from time to time, especially in high risk situations. However, if you are investing in a diversified fund, such as the Russell 1000 Index ETF, the impact of a single stock going bankrupt is very, very small.
Volatility is the reality that security prices do not move up in a straight line, but fluctuate up and down over the short to medium term. The challenge is that it is difficult for our brain to distinguish between a temporary drop (market volatility) and a permanent loss.
The anxiety from a loss can cause not just emotional stress, but actually trigger a physical response in our body chemistry. The evolutionary response to danger is to flee, which for investors, means the strong urge to get out of the market, protect our capital, and stop the pain we are experiencing.
Unfortunately, selling during a period of market volatility has the tragic consequence of turning a temporary drop into a permanent loss. Most investors under perform the overall market precisely because they sell during times of stress. It is essential to recognize that market volatility is just a temporary drop for a long-term investor and be willing to stay the course during these periods.
Here’s how we can use this behavioral understanding to our benefit:
1) Many investors would say that the past 15 years have been horrible in the stock market. The reality is not so bad; if you had invested in the S&P 500 Index ETF (SPY), you would have had a 4.97% annualized return over this period. That equates to a 107% total return, a little more than a double. That’s better than most would assume, because the agony of the losses we’ve experienced is much more intense and memorable than the gains we have actually received. This phenomenon is called loss aversion.
2) If we reframe market volatility as “opportunity” rather than “danger”, then we can profit by being willing to buy when the market is down. People love buying their holiday presents when stores have a 20% sale, but when the market drops 20%, no one wants to invest. If you view a drop as a great chance to buy stocks on sale, then you will realize that the past 15 years have given investors incredible opportunities to profit. And while we shouldn’t try to time the market, we can dollar cost average by making regular contributions to our accounts to take advantage of volatility.
3) We have each client complete a risk tolerance questionnaire before investing. Our goal is to choose an asset allocation which we can stick with, through the inevitable ups and downs that will follow. It’s easy to be aggressive when the market is moving up, but it’s better to invest with an understanding of how you will feel when the market does have a correction.
4) Many investors will create a long-term investment strategy and then proceed to evaluate their portfolio performance on a very frequent basis, such as monthly, daily, or even hourly. The more often you look at your portfolio, the more often you will be tempted by the thought of “Don’t just sit there, do something!” This is where we have to recognize that the emotional, physical urge to react is at odds with the rational process of sticking to a plan. If you want to act in a long-term manner, you cannot think in terms of short-term results. For many of us, it is better to look at your accounts less often, rather than more often.
No matter what you’re feeling about the current market volatility, remember that I am just a phone call away and happy to listen to your concerns, talk strategy, and share the opportunities available in today’s market.
Data from Morningstar, as of 12/31/2015