Why are we talking about a downturn?
The current bull market, the second longest in U.S. history, is over 8 years old. The S&P 500 Index, as a measurement of the overall stock market, is up 265% since it’s low in March of 2009. News media and financial analysts have been speculating on when this bull market will end for several years now. We all know what goes up, must eventually come down.
If the market is going to go down, why not pull out now?
There is a very good reason to stay invested even when you suspect the market is heading for a correction. As Peter Lynch, one of the most successful mutual fund managers of all time, famously said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
The reason investors lose money trying to time the market is that no one has been able to consistently predict when the market decline will begin or how long it will last. Therefore, no one can consistently predict the right time to get out of or back into the market.
Keep in mind that a bear market does not usually occur as a straight-line drop in stock prices. Instead, the market’s performance is likely to be jagged, with periods of price increases followed by declines. In addition, recoveries often occur unexpectedly and rapidly. As you can see from the chart below, missing even just a few of the market’s best days can dramatically affect your returns.
Source: Copyright © 2014 Ned Davis Research, Inc. All rights reserved. Total return includes dividends. These calculations do not include any commissions or transaction fees that an investor may have incurred. If these were included, it would have a negative impact on the return. The S&P 500 is an unmanaged index and cannot be invested in directly. Past performance does not assure future results.
What can we do?
There are three important things we do at Bay Point Wealth Management to help clients prepare for and cope with a downturn in the market.
- Have the right allocation for your situation. We cannot predict or control the ups and downs of the market, but we can control how much we will participate in them. Reports about bull and bear markets generally focus on the overall U.S. stock market. However, a diversified portfolio, one that includes bonds, international stocks, real estate and other types of investments, will not perform the same as the overall stock market. Diversification does not eliminate the possibility that portfolios will decline in value, but it generally means that portfolios will neither go up nor down as dramatically as the stock market.
This is an excellent time to review your allocation and understand how much your portfolio could participate in a market decline. Keep in mind that to the extent you want to avoid the declines, you will also have to be willing and able to miss out on the market gains. Historically, market gains have far exceeded market losses. On August 12 1982, the Dow was at 777. On January 14, 2000, it was at 11,722. Despite periodic descents, it achieved a 1500% gain in 17½ years. It has nearly doubled since then. This gives you an idea what the market is capable of doing and why most clients should be invested to some extent. Finding the right mix of investments for your situation is essential.
We have been reviewing portfolio allocations and potential losses in our recent client meetings to make sure clients are prepared.
- Rebalance. Rebalancing means buying and selling securities within a portfolio to keep it in line with its targeted allocation. This is important both during market rises, as well as during declines. When the market rises, rebalancing prevents portfolios from becoming too risky. When the market declines, rebalancing helps portfolios recover faster.
Over the last five years, the S&P 500 Index achieved an average annual return of over 13%. During the same period, the Barclays US Aggregate Bond Index achieved an average annual return of just over 2%. Without proper rebalancing, a portfolio of stocks and bonds would naturally have become much more heavily weighted in stocks because that portion of the portfolio would have grown more. This would greatly increase the portfolio’s participation in any coming downturn in the market. With rebalancing, stocks would be sold and bonds purchased to keep the originally intended allocation and risk level.
Conversely, when the stock market declines, bonds are sold and stocks are purchased to maintain the targeted mix. This means purchasing additional shares of stock at the lower prices caused by the correction. As the market recovers, you now own more shares of the rising stocks. This speeds your overall recovery time.
- Have patience. It can be helpful during times of anxiety and fear to look at the market’s track record. While the past cannot predict the future, we do see repeated trends. According to a study by Anthony Valeri, if you had invested in U.S. stocks on the exact day of a correction (a decline of 10% or greater) the average time it would take to recover your losses was three years. Only after the Great Depression did it take longer than 10 years. There were only four instances where it took more than 5 years. Neither bull markets, nor bear markets last forever. Whatever happens next, one is almost certain to follow the other eventually.
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