Last week the stock market continued its October rout as the S&P 500 neared a 10 percent correction from last month’s highs. Other asset classes such as US small companies and international developed markets are well into correction territory. Even bonds have faltered to some degree. How should we react to this bad news?
With an unpredictable Election Day just over a week away, a nascent trade war brewing with China, and continuing interest rate hikes, there are many reasons to sit this market out. In truth financial markets this year have returned closer to normalcy. Last year the S&P 500 went up every single month for the first time in history, lulling us into a sense that we should expect double digit returns with no volatility.
If you subscribe to the idea that financial markets are largely efficient, we should not expect high returns with little to no risk. Indeed, one of the first tests in analyzing a potential investment is whether it promises superior performance without associated volatility. If guaranteed growth is promised free of risk, it invokes the specter of Bernie Madoff rather than the wisdom of Warren Buffett.
So we should embrace (albeit reluctantly) this market turmoil. If investing in the stock market were a riskless exercise, then we would only expect modest returns. Go to a reputable online bank, you’ll find that they’ll pay around 2 percent on savings with an FDIC guarantee, while ten year Treasury bonds pay just above 3 percent. If you want returns beyond those, you’ll need to take some risk.
But who needs a lecture when your portfolio is down $15,000? I get that you want to stop the hemorrhaging. You need these funds to grow in order for you to retire and to put your kids through college. Losing the equivalent of a few months’ salary in a matter of weeks is not easy.
Of course, you could sell everything right now and go to cash. You’ll get back into market later, you may think. While this is an alluring vision, being a successful market timer requires that you get two decisions right: when to sell and when to get back in. It would require otherworldly insight or luck to get just one of those calls right let alone both of them.
Instead you should use this volatile time to reflect if you are invested too aggressively given your goals, resources and savings rate, and response to risk. If you’re balking at your portfolio’s decline now when it’s down 5 percent from its high, that’s useful to know before we go through the next bear market. This could be a good time to adjust your target mix of stocks and bonds as you don’t want to find yourself panic selling after the market has declined.
To keep your discipline, have an investment strategy in place based on your net worth, risk tolerance, goals, spending, and age. Your policy statement should detail target percentages of your investible assets for stocks and bonds, and under what circumstances you will rebalance. You can also use target retirement funds that do the rebalancing for you.
Having at least a five year investing window helps tremendously to keep your nerve during market declines. If you’re nearing or in retirement, this can met by guaranteed investments maturing over the next five years that combined with other sources of income could cover your annual expenses. If you have many years until financial independence, five years is the timeframe required to give a regularly rebalanced, diversified portfolio time to grow and recover, if needed.
A portfolio of 60 percent US large and small company stocks and 40 percent of intermediate Treasury bonds rebalanced annually has been positive over every five year period dating back to 1973. That’s not to say there won’t be rocky times during any given five year period as this strategy was down more than 25 percent during the depths of the Great Recession. But with patience and regular rebalancing, the portfolio quickly recovered. By having an appropriate and documented investment strategy in place and at least five years to let it work, you can sail through market turmoil with peace of mind.