The choppy, volatile waters of many public beaches have lifeguards to protect beachgoers from harm. Even the sanguine waters of community pools offer such protective services. And they have a shallow end to acclimate the non-swimming population to the aquatic environment in a safe fashion.
So why does the stock market — a seeming volatile sea complete with a deadly undertow — not offer some such protection?
For many of the market’s newer investors, recent events constitute the first significant downturn of their investing lives. The latest bull market, while overall somewhat anemic by bull market standards, has pulled inexorably upward since 2009. And the last year has certainly helped to pull up its performance numbers.
Then in a series of what may seem to be abstract events, as many investors wouldn't consider them as harbingers of investment performance, the market began a short and reportedly exciting period of decline.
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The news media has told us that this is quite significant. Unprecedented, in fact. The largest one-day points drop in history!
A more appropriate reaction? Yawn.
The Truth About This Stock Market Correction
The largest one-day points drop in market history was a decline of less than five percent. It doesn’t register as one of the most significant percentage declines by any reasonable scale.
But somehow putting the decline into context isn’t a newsworthy thing to do. Putting it into perspective would be sensible and rational, but it wouldn't sell news. News: If it’s not all that bad, then spin it!
The stock market drop is newsworthy in that it does have overall significance. But it isn't something that should have significance in your individual investing life.
Stock market investing means buying into the ownership of corporations — a form of equity investing. Some people find this scary. Yet they place money into equities as part of their daily lives, and do so without fear.
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I offer two analogies: your home and your car.
Homeownership and the Market
A house is an equity investment. As such, we tend to adhere to some common-sense rules regarding homeownership.
First, we don’t generally purchase homes as short-term investments. Some professionals do, but not the average person.
For instance, if you plan to live somewhere for one year, you wouldn’t consider buying a house. If you plan to live somewhere for five years you would probably consider the purchase to be a risky move. But if you plan to live somewhere for 15 to 20 years, you’ll probably think that homeownership makes financial sense.
Second, we pay attention to market trends when we invest. If you own a home, you pay attention to broader indicators of value. Deteriorating conditions in the local school system could be an indicator that you should sell, for example. So could neighbors letting their houses go to seed.
Third, we have an exit strategy. If we know in advance that we will need to be out at a specific time — such as an expected move after retirement — we plan that exit carefully and well in advance.
Fourth, we don’t pay attention to short-term market fluctuations. How many people look at their investment accounts daily or weekly?
Can you imagine getting an appraisal on your home every week? That doesn’t seem to make sense.
And fifth, we barely pay attention to long-term changes. We have an expectation of general upward price movement — a slow, but not necessarily steady upward trend. We appreciate the appreciation, but know that the only important value is its worth when we sell it.
Cars and the Market
Your car is also an equity investment. Did you know that? I hope this information doesn’t keep you up at night worrying about car-value fluctuations!
As an equity, your auto is subject to market-based price fluctuations. Some of them are significant. In general, these variations are reflected in trends, but with some surprisingly sharp changes. For example, the recession of 2008 to 2010 saw a dramatic drop in new car sales.
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The drop led to a decrease in the used-car supply, as fewer people traded in cars. The decrease in the supply of used cars translated to higher values for them. Since there were fewer late-model used cars to sell, dealers could charge higher prices.
As the vehicle market began to recover in 2011, Japan was hit with a devastating tsunami. This severely curtailed Japanese car production, reducing the supply of new cars. While other manufacturers were able to capitalize on the lack of Japanese products, there was some impact on prices, as supply was reduced.
What Does This Say About the Stock Market Correction?
There are a couple of important takeaways from these analogies. For one, equity assets have a purpose. Short-term price fluctuations don’t detract from that purpose. It doesn’t matter whether it’s your house, your car, or your 401(k) — if the asset is appropriate for the purpose, short-term price fluctuations just don’t matter.
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Meanwhile, time does matter. You don’t buy a home to live in for two weeks while on vacation, expecting it to be worth more when you’re ready to go back home. Nor should you expect any other equity investment to increase in value over a short time period.
If your investments are appropriate, you don’t need to micromanage them. You’ll just drive yourself crazy.
Time also matters because short-term fluctuations will happen, whether due to interest rates, tsunamis, or other factors.
How to Protect Yourself Against Stock Market Corrections
So this is what we do: We break our investments into time-based categories and adjust our equity participation based upon those categories. For example:
Funds needed within the next 18 months
Zero equities. None. Zilch. Naught. The important thing for funds needed within the next 18 months is that the funds are available. This means they shouldn’t be subject to market fluctuations — hence no equities.
Funds needed between 18 months and five years from now
Some exposure to equities, but not 100 percent. The amount will depend on your tolerance for risk. The trade-off with increasing equity participation is increased volatility and possibly reduced availability due to these pesky fluctuations. Note that as the goal or time to use the funds moves into the 18 months territory, we move to the zero-equity participation described above.
Funds needed more than five years out
Significant equity participation. Here is where that risk-reward thing has the potential to pay off. The percentage you allocate to equities will again depend on your risk tolerance, among other factors. But for long-term goals, equity investments are appropriate and have made a lot of people a lot of money.
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Most investors will never have the ability to save for a comfortable retirement without using equity investments for a portion of their portfolios.
Let’s step back and take a look at this. Let’s say you just lived through a stock market correction the news media went all kinds of nuts over.
If you own equities for the right reasons, you have no reason to lose sleep. None of the investments you plan to sell in the next 18 months to fund goals or needs is invested in equities. You have some equity exposure in your 18-month to five-year bracket, but not too much, so a temporary drop doesn’t really affect you. If the market decline is long-term, it may have some impact on your goal, but it won’t likely be anything devastating.
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But you do have significant equity exposure in your five-year-plus bracket. This is generally your retirement savings bucket. And it is for all of your retirement — the first five years, the last five years, and hopefully a lot of years in between. So, your five-year bracket is really a five-year, 10-year, 20-year-plus bracket. No reason to worry about short-term fluctuations. What is important is what it is worth when you sell it, just like any other investment. That a long time away.
If you’ve invested in the stock market — in equities — for the right reasons and are cognizant of timeframe, you have nothing to worry about. You’ll lose no sleep. Your market needs no lifeguard.
When bad news hits, novices run to check their account balances. Investors know that they are appropriately positioned for their goals and timeframes. They continue doing whatever they were doing anyway. Then they get a good night’s sleep.