Though it was to be expected at some point, this market sell-off still stings. The rare convergence of surging inflation, extreme stock market volatility, declining bond values and growing geopolitical strife has investors on edge.
However, as extraordinary as the current climate is, it’s essential to remember that we’ve been here before. Lessons from past market sell-offs have taught us that it would be a tremendous mistake to fold up and walk away. While that might make investors feel better in the short term, it could have a disastrous impact on their long-term investment performance.
Watching your portfolio value fall by 20% can be challenging. However, keeping a historical perspective can sometimes ease the pain. Going back to 1928, there has been a market correction of 10% or more in the S&P 500 every 19 months on average. That’s about once per year. Even bigger declines are rare when you stretch the time horizon further than recent memory.
Although the particular reasons for each market sell-off vary, market pullbacks are part of the DNA of the stock market. Here’s a historical breakdown of the frequency and duration of market drawdowns of increasing severity:
- Down 10% about once per year; average duration of 112 days.
- Down 15% about once every 3 ½ years; average duration of 262 days.
- Down 20% or more approximately every six years; average duration of 401 days.
Larger, 30%-plus declines occur with far less frequency, but we’ve experienced two since the turn of the millennium.
The critical lesson to take away from this history, in my opinion, is that following every market decline since 1928, a stronger and more enduring market advance has taken stock prices to new highs.
Human Instinct Is To Do Something, Anything When Fear Strikes
The thing is you can’t fault investors for wanting to flee during volatile market downturns. That’s a perfectly rational response. Humans are wired to act when they feel pain—instinctively, they feel they must do something to ease the pain and feel better. What’s irrational is to sit and brave the massive roller coaster ride of the market, especially as you watch your portfolio value gradually decline.
But that’s for investors who are only informed by stock prices, watching the daily ticks and scouring their accounts, helplessly watching their stock prices go down. That’s an awful feeling that can drive many people to take action, even if it means selling into the depths of a lingering market sell-off.
Never mind that the action results in a permanent loss of capital that will take years to recover. Investors fear the pain of losing far more than they enjoy the benefits of gains. They feel better storing their money in a certificate of deposit (CD) even though they’re losing value each day as inflation eats away at their money. More importantly, the negative, inflation-adjusted returns of a CD or other cash investment cannot create lifetime income sufficiency. Investors overweight in cash to avoid market volatility have a higher likelihood of running out of money in retirement.
For A Secure Retirement, Investors Need To Embrace Volatility
In today’s environment of low yields and declining bond values, investors who want to secure their financial future need to be invested in assets that generate sufficient returns to grow their assets. The challenge for many is that investing in anything outside of cash means having to endure volatility.
I’ve written in the past on why investors shouldn’t fear volatility because, over time, it has worked to their advantage. Since the inception of the stock market, volatility has been the key to positive long-term returns over time. Volatility is not your biggest risk; your most significant risk is how you react to it.
But, if fleeing the market is a rational response to declining stock prices, how are investors expected to stay the course? Remember, I said it was a rational response for investors who are only informed by stock prices. When you are frequently paying attention to stock prices or your account statements, it limits you to a short-term perspective, making it difficult to see past what is currently happening. While selling stocks amid a downturn may seem intuitive, it also deprives you of the means to recover when the market rebounds.
A Well-Conceived Financial Plan Can Get You Through This
On the other hand, investors who are informed by a historical perspective and their financial plan have far less trouble staying the course. Having a sound financial plan helps investors endure periods of market distress.
A well-conceived financial plan factors in the worst scenarios of inflation and the stock market. That’s why, instead of projecting historical returns of 8% to 10%, one could project returns of 5%. It should also factor in an inflation rate higher than the average. A good financial plan is designed to overshoot objectives by being extremely conservative with assumptions.
For our company, we also cushion our clients’ financial plans with enough cash to cover two years of living expenses. That’s so they won’t have to sell any securities when the market is declining, which generally leads to a faster depletion of assets. Bear markets average about 289 days in duration, so a two-year reserve is plenty of time to allow the market to bottom out and then potentially start a recovery phase.
Planning for worst-case scenarios with modest assumptions and a sufficient cash reserve gives investors the confidence to withstand severe volatility and prolonged declines and the conviction to stay the course.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.