The progress pattern of the stock market is always “two steps forward and one step back”. We have been telling clients for months that eventually there will be another stock market “correction”. The S&P 500 posted an all-time high about four weeks ago and is down about 7.5% since then.
It has been over three years since the S&P 500 has experienced a price pullback of 10%. During those three years the market has gone up over 90%. Up 90% and down 10% should not be a cause for panic.
If this is the beginning of a 15% - 20% market correction, it is important to understand that there is a plan in place for your assets that will ultimately have you profiting from the volatility.
Why Diversification is Important? - When the stock market corrects, we see something that is called a “flight to quality”. This is when some stock investors get spooked by the correction and sell their stock investments. When they do so, they need to put their cash to work somewhere so they buy lower-risk investments like bonds which, in turn, push the price of bonds up.
We recommend that even our most aggressive clients hold at least a small percentage of bonds in their portfolio. Not only do the bonds dampen the volatility of the total portfolio but they also provide “dry powder” for us to use to buy more stocks when they are “on sale” at values of 15% - 20% lower than their most recent high.
Sell High, Buy Low - In prior newsletters, we’ve written about the importance of rebalancing an investment portfolio. Rebalancing is simply the act of bringing a portfolio back to its original target allocation by selling some of the investments that have recently outperformed (sell high) and reinvesting the cash into the investments that have recently underperformed (buy low).
We Are Working the Plan - Since the summer of 2011 (the last time we had a stock market correction), nearly all of our rebalance transactions for clients have required taking profits from the stock side of the portfolio (selling stocks) and reinvesting the proceeds on the bond side of the portfolio . If stocks continue to decline, we will be doing the opposite: taking profits from bonds after the flight to quality pushes their prices up and reinvesting in stocks while they are on sale.
According to an independent study by Vanguard, this systematic process can add an additional 0.35% of performance per year to a portfolio.
In the meantime, we understand that it is no fun to watch account balances go down. Remember, corrections are inevitable but so are recoveries. If we understand this and have a plan for what to do along the way, we can actually benefit from the market volatility instead of fear it.
For now, try to avoid the doomsday news reports about the markets. We are paying close attention to your investments on a day-to-day basis, so let our stomach linings take the brunt of the damage instead of yours. We have plenty of tums in the office to get through it for you!