Avoiding Investor Mistakes Made During Corrections

Avoiding Investor Mistakes Made During Corrections

Key Takeaways

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  • As John Templeton famously said: “The four most expensive words in the English language are, ‘This time it’s different.’”
  • Market corrections are painful, but historically, given enough time, they have always given way to new bull markets.
  • Don’t make irrational decisions during unsettling times, or it could take you years to recover.

Whenever your favorite team goes on a hot streak, it doesn’t take long for the sports talk show hosts and die-hard fans to start asking, “How much longer can this winning streak go?” Same goes for a prolonged summer heat wave or a pop song that’s been riding high atop the Billboard charts week after week.

Sooner or later, if history is any guide, the equity markets regress to their mean, but some pundits and media talking heads might have you believe otherwise regarding today’s stock market and economy. Here are some factors that make many inexperienced investors think to themselves, “this time it’s different.” Don’t get fooled and jump to conclusions when you hear:

  • Media and pundit’s predictions
  • GDP too high/too low
  • Consumer confidence is too low
  • Interest rates are too high/low
  • The Dollar is too high/low
  • P/E ratios are too high
  • Inflation/ Deflation
  • The Jobless Rate
  • A Democrat/Republican is in the White House
  • Speculation that taxes will go up/down
  • The VIX (Volatility Index)
  • The Market is at all-time highs and “due for a pullback”
  • Jim Cramer screamed on your TV “SELL SELL SELL!!!”
  • Geopolitical unrest North Korea, Russia, the Middle East
  • Government entitlement programs are too great an expense
  • Defense spending is too high
  • The Deficit
  • The Debt ceiling
  • The Fed signaled to raise/lower rates
  • And on and on and on

Regardless of what was stated above, stock market corrections happen all the time. History confirms that. But, predicting a stock market correction is like saying it’s going to snow in Alaska this year. Part of the challenge is that there are many misconceptions about what a correction is and investors ask me all the time: “Michael, how can we navigate it?”

Understanding corrections

First, I recommend that you gain some perspective about corrections. Doing so can help you make even smarter decisions about your money. As defined by Bloomberg, a correction simply means that a certain asset class (i.e. stocks, bonds, commodities, real estate, etc.) has declined by at least 10 percent during a given time period. A bear market means that an asset class has declined by at least 20 percent during a given time period — more on bear markets later.

By analyzing long-term stock market performance records, you will see that the market has experienced a correction ( i.e. a 10-percent decline) or market pullback in many of the last 37 years. Please see ( S&P 500 Intra-Year Declines versus Calendar-Year Returns) chart below.

So why not get out of the market once it drops 10 percent to avoid a deeper decline into bear market territory? That’s because most corrections, technically speaking, never fall into bear market territory. Historically speaking, per the chart below, the average correction results in a decline of 14.1 percent and typically lasts less than two months. In fact, less than one in five corrections deteriorates into an official bear market.

The danger of over-reacting

I believe it just doesn’t make sense to move your investments into cash whenever a correction occurs. It is illogical to liquidate your holdings and move to cash after the market drops by 10 percent. In this scenario, you may be moving to cash just prior to the historical bottom of the cycle and would potentially miss out on the next run up! (see chart below)

Imagine the chaos of your portfolio if you reacted like this for even just a few of the corrections? To give you a recent example, it is January 1st of 2016 and you smile as your account statement shows you have finally reached the $1 million milestone with a diversified portfolio of U.S. stocks. Then crude oil crashes, and China’s stock market tumbles into bear market territory, thus wreaking havoc in the international markets including the S&P 500. By the end of January, the S&P 500 has dropped 11.8 percent and the value of your $1 million has moved lock-step and declined to $882,000 — an 11.8 percent drop in just one month! Fear sets in. The pundits are screaming: “this is the beginning of the next bear market!” and so you capitulate and sell out your holdings for cash.

You go to sleep that night and tell yourself, “Well, at least I still have $882,000 left. When things settle down, I’ll get back in to the market.” On the other hand, if you had done nothing to your portfolio during the downturn (i.e. you didn’t sell), the market would have rebounded and then some. Not only would you have recovered the $118,000 that you lost on paper at the end of January, but you would have earned an extra $93,900 (not including dividends) during the market rebound that followed the correction. Fast forward to August 2017 and your portfolio would be up $215,000, (not including dividends).

Just know this about corrections (see chart below)

  • Corrections happen all the time.
  • Historically, most corrections have not deteriorated into bear markets.
  • Corrections historically last approximately two months.
  • The average intra-year decline for a correction is minus 14.1 percent.

You should also be aware that given enough time, every single correction in history has given way to a full recovery.

S&P 500 Intra-Year Declines versus Calendar-Year Returns

Sources: FactSet J.P. Morgan Asset Management

Returns are based on price index only and do not include dividends. Intra-year drops refer to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2016. Over which time period the average annual return was 8.5%. The 2017 bar represents the year-to-date return and is not included the average annual return calculation

Guide to the markets — U.S. Data are as of June 30, 2017.

Conclusion

Armed with the information provided to you from this post, it may seem ridiculous to panic and go to cash whenever a correction occurs. In my next post, we’ll take a closer look at bear markets. They’re more severe and unsettling than corrections, but I believe not severe enough to take you away from your discipline and long-term plan.

If you or a business owner you know is concerned that the markets are running out of steam, please don’t hesitate to contact me. I’d be happy to help.

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Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gold Family Wealth, LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Gold Family Wealth, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gold Family Wealth, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Gold Family Wealth, LLC’s current written disclosure statement discussing our advisory services and fees is available upon request. If you are a Gold Family Wealth, LLC client, please remember to contact Gold Family Wealth, LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services.

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