Stock markets around the world have had a very tough summer. Most are down more than 10% from recent highs and volatility has increased substantially. A currency devaluation and significant slowdown in China along with uncertainty about the Federal Reserve raising interest rates later this month are the main culprits. Investors are nervous. As I write this, the Dow is down more than 2,000 points since May and the S&P 500 Index is down 10% from its highs earlier this year.
So what are we doing about all this? Buying stocks.
A client of ours called recently to ask: “Under what circumstances would you sell our stocks?” I told her that there are basically two reasons we sell stocks:
- If a client directs us to sell his/her stocks
- Stocks become very popular and trade far above their historical valuations
Not among our reasons is “When markets are in turmoil, stocks are down and investors are nervous.”
Know the Animal You are Riding
If you are invested in the stock market, it is critical for you to understand the historical behavior of the market animal you are riding if you are to avoid costly mistakes.
Since 1950 there have been, including the current one, 33 market declines of 10% or more. So, in how many of those cases has the market failed to recover to trade at new highs? Only once out of 33 instancesthe current decline. On average, 10% declines last about 200 days. But markets can trade sideways for years and years, testing the mettle of even the most patient of investors. Neither we (nor anyone else) knows how long this correction will last. Perhaps stocks regain their highs in six months; perhaps the Dow is down another 2,000 points. But whether the recovery takes three months or three years, the historical data make it clear that investors who have put money to work during market declines have been rewarded with higher returns.
The Worst Mistake
The worst mistake long term investors can make is to sell stocks during a market downturn. Emotionally, it is the easiest decision to sell when prices are down and things are looking bleak in the economy. Financially, it is incredibly destructive. The problem is that this is the time when markets are poised to generate very high returns. Dour sentiment and a lousy economy are a great recipe for cheap stocksand cheap stocks are a great recipe for higher future returns. Take for example the bleakest moments of the 2008-09 financial crisis. In the spring of 2009, our banking system seemed on the verge of being nationalized, General Motors went bankrupt and people were beginning to believe General Electric would be next. No one (including us) knew how things would shake out. But as it happened, intense pessimism combined with cheap stocks served up the best buying opportunity in decades for investors bold enough to step in. In the six years since then the Dow has rallied more than 9,000 points.
Neither we nor anyone else knows when or how we will reach the bottom of the current sell-off. Will stocks get cheaper? Perhaps. What we do know for a fact, however, it that today stocks can be had 10% cheaper than just four months ago.
Know Thyself, Investor!
If investors are to position themselves to profit from market downturns, they must know their own tolerance for risk. Investors who have everything invested in stocks and are not prepared to tolerate a 20% or 30% decline are making a fundamental (and completely avoidable) mistake which at some point may cause serious financial pain.
If investors know 1) how much risk they can tolerate, and 2) understand the historical behavior of the market animal they are riding, they will be prepared use a sensible and unemotional portfolio rebalancing strategy to weather bad markets and prosper in good markets.
Thus, it is very important not to invest too much of your portfolio in stocks if you are to have the courage to buy more when they are down. If you own 100% stocks there is no money (and probably no enthusiasm) left to invest further in stocks when they are down. If you have only 50% in stocks and a 10% decline happens, however, it is psychologically much easier to bring your stock allocation back up from 45% to 50% with fresh funds.
We use technology from Riskalyse to help investors determine (in dollar terms) their risk tolerance. Visit us our short Risk Questionnaire and spend two minutes to calculate your Risk Number. Once you have a portfolio that suits your needs and circumstances, you will be emotionally prepared to move when markets offer up an opportunity.
To learn more about how we manage client portfolios, please visit us at www.orionportfolios.com
By Peter C. Thoms, CFA