During the 2008 financial crisis, from the market’s peak in October 2007 to its bottom in March 2009, the S&P 500 dropped in value by more than 50%.
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Not surprisingly, many people panicked when their account balances, and lifetime savings, fell so drastically. Deciding to cut their losses, they sold their stocks and moved their money to the safety of low-yield investments such as Treasury bills and CDs. Over the following decade, however, the overall market return was more than 400%!
Many people who moved their money out of the market experienced all of the pain of the market drop with little to none of the benefit of the returns that followed. On the other hand, investors who weathered the volatility and stuck with their long-term plan were rewarded for their patience.
A Little Volatility Is a Good Thing
Market corrections are normal and necessary for a healthy stock market. Long-term investors who have a strong plan don’t need to be afraid of these corrections. If you think of a rising stock market as a pressure cooker, corrections are the pressure release valve that periodically allows enough steam to escape to prevent everything from boiling over. It’s only when corrections don’t occur often enough that investors should be wary.
Human nature makes it hard for us to be patient when it comes to investments, however. Even in the best of times, people tend to make financial decisions that go against their own best interests. With the added stress of volatile financial markets, it becomes difficult to make decisions that support our long-term investment plan. There are a few natural human tendencies that make it particularly difficult:
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Loss aversion makes the pain we associate with losses far more intense than the pleasure we associate with gains, so we tend to err on the side of caution. This is why investors often sell their winners while holding on to their losers, and why so many people move their money to “safe” assets when volatility increases.
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Herding bias is our tendency to follow what everyone else is doing, even when they are behaving in a way that isn’t in our individual best interest. This helps explain our tendency to buy high and sell low, and our reluctance to do something different than what everyone else seems to be doing.
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Recency bias tempts us to make decisions based on the most recent information and news instead of stepping back and looking at longer-term trends. This can lead us to overreact to short-term disruptions in the market in a way that goes against our long-term interests.
To counteract these natural tendencies requires a steady hand and a strong commitment to concentrating on your goals and your financial plan despite all the noise and distractions of the moment.
Maintain Your Long-Term Focus
Warren Buffett, a highly successful investor, once said, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” His point is a good one, because if there’s one lesson the stock market has taught us repeatedly over the years, it’s that investment success depends more on how long you are in the market than on your timing of the market. Of course, it’s never easy to stick to your strategy while other investors scramble for less-volatile money market funds. And if you’re dealing with a short investment window (for example, if you are close to retirement), your top priorities should be locking in gains and exploring asset protection strategies.
But for those with at least a five-year investment time horizon, market volatility may provide a valuable opportunity to reduce the average share cost of your investments. You can do this by using a dollar-cost averaging strategy of periodic purchases, either through regular contributions to your employer’s retirement plan or through monthly transfers of cash into a brokerage account.
Make Sure You Rebalance
Over time, your portfolio allocations may change a lot, because some investments may grow more rapidly than others. After a prolonged bull market, what was originally an allocation of 60% stocks and 40% bonds may have gradually drifted to 75% stocks and 25% bonds as a result of the much faster growth of stocks. This can result in a lot more investment risk than you planned on or need. On the other hand, after a major market correction, that original portfolio of 60% stocks and 40% bonds could end up at 45% stocks and 55% bonds as bonds outperform stocks. This allocation may not be enough risk to achieve your long-term goals. By periodically rebalancing your investment portfolio—buying and selling shares to bring it back to your target allocation—you can manage your risk more effectively. Since rebalancing involves transactions, however, you and your advisor need to approach the process thoughtfully and strategically to help minimize costs and any potential taxes from long-term capital gains.
Stay the Course
Markets rise and markets fall, but the long-term trend has always been for the market to go higher. Although it can be frightening and unnerving, periodic volatility is an unavoidable part of this cycle. When you have a sound long-term portfolio strategy, the best thing to do can be nothing.
Key Takeaways
Volatility is necessary for a healthy stock market.
Although volatility can be stressful, the best way to handle it is to stay focused on your long-term plan.
Trying to time the market is a recipe for investment failure.
Use volatility as an opportunity to acquire lower-cost shares by continuing regular contributions to your retirement and investment accounts (dollar-cost averaging).
Periodically rebalance your portfolios during times of high volatility.
Market changes can cause your target allocations to drift, leading you to take on too much or too little risk for your investment goals.
