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The global economy is sluggish. Falling consumer demand is dragging down commodity prices, which has hit energy companies and emerging countries especially hard. A slowdown in China’s expansion has led to a severe correction in its stock market, which is now spreading to other markets around the world.
It’s human nature to get emotional about your money when you hear about a market meltdown and see your account balances shrinking. But one way to counter fear is with faith — in this case, faith that things will eventually calm down and that when they do, you’ll be well positioned to succeed. To that end, here are some “commandments” to follow in the midst of market volatility to maintain your sanity and preserve your portfolio for the long run.
Thou shall not sell
Some investors panic and sell all or most of their holdings at the first sign of trouble. This simply makes no sense. We expect markets to “correct” and to underperform at times, so we should sit tight and stick to our plan. We invest in stocks to get a return, but that return is highly correlated with volatility. Therefore, if we want higher returns, we must be able to accept the downturns along with the upswings.
The stock market has been overvalued for some time. Unfortunately, no one knows when and how it will ultimately correct. It may come as a large crash or as a prolonged period of lackluster returns. As the economist John Maynard Keynes famously said, “The market can stay irrational longer than you can stay solvent.”
That is why market timing is so difficult. You must be right twice — once when getting out and once again when getting back in. Most people who converted to cash in 2008 did not reinvest in the market until it was well into its recovery. They missed months, if not years, of appreciation.
Thou shall not have unrealistic expectations
Market cycles are normal. However, over the past few years, the U.S. stock market appeared immune to a downturn. At the beginning of this year, the S&P 500 Index, a proxy for large company stocks in the U.S., had not experienced a correction of 10% or more in over three years. The higher-than-average returns we experienced in the past five years cannot be extrapolated into the future. It is unrealistic to think the market will deliver double-digit annual returns indefinitely. In fact, because of current valuations, most analysts expect far lower returns of approximately 4% (before inflation) over the next 10 years.
In addition, returns are neither uniform nor constant. There will be swings, both positive and negative, around average returns. The variance can be quite large. Consider this statistic: From 1928 to 2014, the average annualized return for the S&P 500 was 9.6%. Guess how many years the actual return for the year was within 25% of that average — meaning, between 7.2% and 12.0%.
The answer: three. In an 87-year period, there were only three years in which the actual return fell within 25% of the average return over that period.
Thou shall not covet a particular asset class
Asset classes do not all move in the same direction at the same time — and that is a good thing. If a portfolio is constructed properly, it will include asset classes that have low correlation with other classes. This means that at any point in time, some assets or funds will be up while others will be down. This is done on purpose to reduce the long-term volatility of the portfolio. In fact, if you don’t have at least one fund or asset class in your portfolio that is down at any one time, you are probably not properly diversified!
Bonds have been unpopular with the media and investors because of their historically low yields and the expectation of an interest rate hike by the Federal Reserve. But bonds are now a welcome part of our investment mix. They’re enjoying a lift from a “flight to quality” during the recent downturn and are serving their purpose by acting as shock absorbers to reduce losses.
Thou shall not worry about short-term returns
Short-term performance is not meaningful when you’re investing for the long run. Emergency reserves and money that will be needed within five years should not be invested in your longer-term investment portfolio. They belong in FDIC-insured high yield savings accounts, CDs or high quality bonds. This helps ensure that you can stay invested for a full market cycle (typically four to five years) and avoid the risk of forced liquidation (at possibly depressed prices) to cover expenses.
If you are approaching retirement, you should have already been gradually de-risking your investments (moving into more bonds and cash) to protect yourself from what we financial planners call “sequencing risk.” This refers to experiencing a major drop in your investments at the most vulnerable time in your investing life—five years prior to and after retirement.
A prudent financial plan anticipates these corrections and is stress-tested to ensure that spending goals over your lifetime will be met despite variable market corrections. This is why having projections with prudent assumptions for your retirement is so important. It provides you with peace of mind.
Thou shall control what you can control
During a market downturn or a time of increased volatility, it is important to focus on the things you can control. First, make sure you are invested in low-cost funds. Also, reevaluate your attitude toward risk. If you are overly anxious or can’t sleep due to worrying about your investments, it may be a good time to reduce your equity exposure. (For example, reduce your stock allocation by 10 to 20 percentage points depending on your current allocation and risk personality).
After large corrections, it is often helpful to rebalance the portfolio, as this allows us to buy some assets “on sale” and sell others that are overvalued.
Rebalancing is normally only needed once a year or after a major correction. Studies show that systematic rebalancing can add up 0.7% to your return over time.
Thou shall not dwell
It is customary for the media to hype market downturns. This drives ratings and online traffic and sells papers. But unfortunately, this only exacerbates the short-term pain we feel from these perceived losses and enhances our anxiety. A loss is realized only if you sell your investments and lock in that loss permanently. Remember that markets recover over the long run. Try not to look at your balances too often, and try to tune out the media ito stay level-headed. In fact, it is probably wise to only look at your investment statements once a year and evaluate performance over longer periods, such as five to seven years.
Finally, maintain your composure by counting your non-financial blessings. Focus on the things that are positive in your life: health, relationships, achievements — things that all the money in the world can’t buy, no matter how it’s invested.
Image via iStock.