What to do when markets turn sour

Apr 04, 2018 | Sam McLaughlin


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The world seems more uncertain now than it has in a long time. A proper plan and a long-term view can turn risk into opportunity by showing you the direction that you are trying to go and charting the course to get there.

The world seems more uncertain now than it has in a long time. Financial expectations change week to week and radical changes in policy seem to be happening even more frequently. It’s easy to get overwhelmed by looking at your investments. But a proper plan and a long-term view can turn risk into opportunity by showing you the direction that you are trying to go and charting the course to get there.

 

Good news or bad news, what are individual investors to do in the face of uncertainty in the global markets? Focus on what you can control. Meeting financial goals is less about shooting the lights out, and more about knowing what you need and when, and working to increase the odds of getting there. There are three major controllable factors that influence an individual’s success:

  1. Your savings rate;
  2. Your asset allocation;
  3. Knowing your temperament.

 

1. Your savings rate         

How much you spend, how much you save, and what you do with your savings when you have them is theoretically the easiest of the three to control, but practically the hardest to change. For most of us, our incomes are fixed (whether through wages, pensions, draw-down of assets, etc.), and we all have fixed expenses that must be covered before anything else takes place. And most people work to afford to live a fulfilling life, and that takes money, also. The amount that actually gets socked away (or, for retirees, not withdrawn from savings) is important to overall goal achievement, but putting a plan in place and sticking to it is really the most important part.

 

By way of illustration, a colleague of mine pointed me to a thought experiment conducted by market thinker and blogger Ben Carlson^, which I have updated and reproduced the logic of here. Say you saved $5,000 per year for each of the first ten years of your working life starting in 1970. Every decade after that, you upped your savings by a further $5,000 (so $10,000 per year in 1980, $15,000 per year in 1990). Say, too, that you were the worst market timer in history, and you only bought into the S&P500 in lump sums just before the major bear markets of 1972, 1987, 2000 and 2007*, but never sold. By 2013 you would have saved a total of $575,000 from your earnings. That portfolio, however, would be worth a whopping $2,750,000. Timing the market helps, sure, but time in the market is far more important.

 

If you have a savings plan, great or small, market corrections can be viewed as an opportunity rather than a calamity. They offer the opportunity to put money to work by buying assets at a lower price. If you have the time, and you have the stomach, there is no better time to invest.

 

2. Your asset allocation 

The value of leaving your investments to work for you and to buy low in weak markets is worthless, however, if your timeline isn’t long enough. Money is more than a number on a page; it represents some mix of the things that money buys at some point in the future. The more you (and we) are aware of your needs, the more we can prepare for them. If you have less time, some of your assets should be allocated to more secure investments. Stock markets consistently provide the best overall return over the long run, but the variability of returns year-over-year argue for planning for your needs and holding less volatile fixed income to fund short-term needs. Since 1926, intermediate-term government bonds have never performed worse than -5% in any calendar year. Compare that to the worst one-year return on stocks (-38% in 1974, when my father started his career) and it’s easy to see the advantage of “buying” a little certainty.

 

When evaluating your asset allocation, it is equally important to understand that stocks are ultimately an important way to fully participate in the long-run growth of the economy, and if beating inflation is important to achieving your goals, participating in that growth is going to form the base of your strategy. The nominal return of intermediate-term bonds is 5%, but when you take inflation and taxes into effect, the real return shrinks to about 1%. Stock returns after inflation and taxes have averaged 6% over the same period. Owning companies—the engines of the economy—is one of the best ways to save for needs that extend beyond the short-term.

 

3. Knowing your temperament

A financial plan can be completely derailed by taking risks that we can’t “stomach.” It’s important to realize that it is completely normal for stocks to sell off from time-to-time. We may be forgetting this, since we have not experienced a bear market (-20% pullback) on the S&P since 2009, and investors may be getting complacent. If we want to avoid the pitfalls of selling out at the bottom (the “I can’t take this anymore” reaction), we need to evaluate what we would do if stocks sold off before the sell-off happens. As long as a plan has taken into effect your needs, time and fortitude can bail out any market correction. The problem is that losses are painful when they are happening, and we’re simply not programmed as people to deal with them in rational, unimpassioned terms; our instincts get in the way of calculating logic. Investors should—especially when markets are rising—evaluate what their reactions will be when markets turn. We need to say to ourselves, “As long as my planning is good and my short-term needs are covered, what would it feel like if my portfolio was down 10%? What about 20%? 50%?” Thinking about these scenarios ahead of time helps us to refocus when theory turns into reality and keeps us from making decisions that damage those long-term plans.

 

Conclusion

To thine own self be true. Know what you have and what you hope to accomplish ahead of time. Know how you plan to get there and, most importantly, what you will do and how you will react when three steps forward becomes one step back. Think about all of this ahead of time, and hearken back to those plans when market volatility makes you unsure.

 

^ A Wealth of Common Sense, pg. 123, Ben Carlson, ©2015, John Wiley & Sons

*  Stocks, Bonds, Bills and Inflation Classic Yearbook, ©2015, IbbotsonIbbottson & Associates