Many stocks and indices have recently gone through a “pullback” or a “correction.” The jargon is usually technically defined as a pullback when stocks or indices go down from a recent high by 9% or less. Correction occurs when the 10% decline level is crossed and down to a 19.9% decline. Once the 20% decline limit is crossed, many might say a “bear market” exists for a stock or a stock market index.
Corrections can seem very scary when they occur. It is not fun to watch your portfolio go down in value. But, investing is not really supposed to be “fun” anyway. Although, admittedly, it can be fun to watch a portfolio increase in value, it is wise to attempt to remove emotion from one’s portfolio. Responding emotionally to one’s portfolio, whether up or down, may lead to making mistakes.
When a portfolio is going up for a long period of time, one might be tempted to hold onto positions that have been doing well. It might make you feel good to see a particular investment keep going up and you might think you would feel badly if you reduced your exposure and then had to watch as it continued going up in value. (See our previous commentary, “Bias.”)
When a stock or a portfolio is declining in value, especially if the decline is rapid and large, it can make an investor feel scared. The temptation is often to want to sell, either the stock or the portfolio. It is a natural reaction and nothing of which to be ashamed. Nobody enjoys seeing the value of their portfolio lose value.
Investing involves the risk of seeing values go down. Then why invest at all? Because the risk pendulum swings both ways with most types of investments and we invest for the upside risk. There is another risk that pushes us to invest for our long-term goals and needs and that is inflation. Were a person to put money under the mattress and keep it there for years, then take it out to spend, one would discover it will buy a lot less than it used to buy, even though the amount of dollars is unchanged. For example, were you to put $10,000 under the mattress today and take it out to spend 20 years from now, assuming 2% average annual inflation, the purchasing power of that $10,000 would equal only about $5,140.53 in today’s dollars.
Without getting overly complex, there are two basic kinds of investments. Stocks and bonds. In very general terms, the goal in investing in bonds long-term is to attempt to preserve the purchasing power of the dollars after inflation and taxes. Suppose you had a bond paying you 3% interest per year and out of that 3% taxes took 1% of the interest away and you reinvested the net interest back into a bond paying 3%. If inflation is at 2%, then even though the value went up by a net 2% after taxes, your purchasing power would be the same as when you started.
Historically, which is not a guarantee of future results, stocks generally tend to go up in value over time faster than the rate of inflation. This is why most long-term investors put some of their investment money into stocks. Yes, stocks go up and down in value usually a lot more than bonds, but over time the goal of stock investing is to grow money faster than inflation and taxes so that one actually increases overall purchasing power.
Why do stocks tend to go up in value faster than inflation? Companies generally try to pass on the inflation that affects them by raising prices and passing that onto consumers. Companies also usually try to increase the amount of products they sell. So, if a company passes on inflation, that increases their gross sales at the rate of inflation. Everything else being equal, one would expect the stock to go up in value by the rate of inflation that was passed onto the purchaser of the products. If the company then opens a new market or creates a new product and brings in more gross sales from the new product or market, the stock should be expected to go up in value even more than just the inflation that was passed to consumers. The board of directors of a company should be expected to push the CEO and other executives of the company to sell more products.
Before someone invests anything, the investor should design a strategy. This strategy would be based on needs and goals and various assumptions about things like inflation, interest rates, stock returns, etc. Those considerations will lead to an allocation strategy of a certain amount of bonds and a certain amount of stocks (again over simplifying, but this is essentially what is done). Part of the decision for an allocation is the risk tolerance of the investor for up and down value moves and the risk of inflation that might keep the investor from reaching the set goals and needs. The risk to moves in portfolio value should be set at a level, if possible, that will allow the investor not to feel overly emotional, leading to making emotional reactions at a bad time.
When the correction is in process, what should an investor with a proper allocation do? Usually, nothing should be done. A sound allocation strategy is formulated with the knowledge that value swings are expected to occur, and therefore a correction is not usually a reason to change a strategy. Should the investor have idle cash that is not needed for immediate purchases or emergency funds, then the wise thing to do would likely be to add the idle funds to the part of the strategy that has seen the declines. Yet, Wall Street seems to be the only place a sale sees people resist buying during the sale.
Once the correction is over, we encourage our clients to make a reassessment of their feelings during the correction. Review, reflection and possibly reconsideration of the allocation and risktolerance level are a good ideas. Once the portfolio value has recovered most or more of its pre-correction value would often be the wiser time to adjust the allocation. Without the emotion that occurs during the correction, many investors reflect and decide the strategy originally implemented is indeed the correct one. That decision should be noted in the investor’s mind and put away and brought out at the next decline to encourage sticking to the strategy.
When corrections are in the process of coming to an end, markets may often be very volatile. Investors should not be surprised or lose heart should stocks do a “retest” of the recent lows. That is quite normal in the process of correction.
A correction is not a bear market. Bear markets are long, protracted periods where asset values decline. As applies to stocks, these generally occur due to economic downturns. At this time, the economic data that is being reported does not seem to portend a bear market. An unexpected shock could always occur that would cause a change in economic direction, but for now the direction of the economy seems to be up and stocks generally follow the economy’s direction.
We are here for you, our clients. We are always happy to discuss with you the allocation chosen and the risk levels in your portfolio. Please, do not hesitate to contact us with any concerns and we can help you assess the situation as market conditions relate specifically to you and your goals and needs.
Richard Tomes, CFP®
Total Wealth Planning and Management, Inc.