The Stock Market Had a “Correction”—Now What?
It’s been several years since we’ve seen a quarter with as much volatility as the one that ended September 30, 2015.
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 simply eliminating equity exposure entirely once the 10% threshold has been breached can help them to avoide large losses.
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 the collective assessment of the future by millions of market participants and the expectation that equities in both the U.S. and markets around the world have positive expected returns.
Our research shows that U.S. 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 markets outside of the U.S. are similar.
Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken. Rather, volatility is what we 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.
If you held on for the wild ride during the quarter, the October rally is your reward. As of this writing in late October 2015, the S&P 500 is back in positive territory for the year. The index is up 11% since its 2015 low in August.
As disciplined creators of wealth for our clients, we strategically rebalance portfolios and harvest tax losses when markets present such opportunities. In this way, our clients are more likely to achieve long-run investing success.