On Dec 31, 2015 the S&P500 Index closed at 2,045.
On Jan 14, 2016, it closed at 1,890.
By my math, that’s a 155 point drop, or 7.6%. In 2 weeks.
Even worse is the drop from the 2015 high of 2,131 (achieved on May 21). From that height, the market has corrected 241 points, or 11.3%. Congratulations, we’ve officially achieved a “Market Correction”. You can see the volatility in the above chart (compliments of Yahoo!Finance).
1) Is this correction GREAT news, TERRIBLE news, or JUST news?
2) What am I doing with my investments today?
The balance of today’s article is focused on answering those two questions.
Question 1: Is This Great, Terrible Or Just News?
Time for the infamous “It Depends”. In this case, it really does depend. In reality, this market correction is all 3. Inevitably, folks reading this fall into one of three scenarios, and how you should view this correction is driven by your current situation:
“GREAT” NEWS! If…
Anyone under the age of 45 should be doing High 5’s around the house. I tell “the younger folks” at the office that this “correction” (the definition of correction is a decline of greater than 10%) is the best thing that could happen to them. Well, that’s not actually true. Better would be a full on bear market. Bring on the full blown bear, you want a 50% correction of the 2008-09 sorts. Great news.
Why? 3 Reasons:
- Time Horizon: You’ve got a long time frame before you’ll need to access the money.
- You’re Buying On Sale: If Ford drops the price of their F150 by 11%, you’re happy. You should view Ford stock the same. 50%’s even better.
- Stocks were over-valued: Stocks prices are driven by earnings. When that ratio between the two gets too high, future returns are diminished.
The chart below shows the “CAPE” (Cyclically Adjusted Price-Earnings Ratio). As this article points out, many argue that when the ratio of stock prices to earnings trends high, future expectations for returns should be diminished. I certainly agree, and have lower return expectations for the S&P500 over the next 5 years than I do for other asset classes where the CAPE ratio is much lower. Emerging Markets, for example, have a CAPE of only 13.5% vs. the S&P 24.4%, so one could argue that the return with Emerging Market stocks will outpace the S&P 500 over the next 5-10 years. As you can see, the recent “correction” has reduced the CAPE for the S&P 500. Over time, this should result in higher returns from today’s level.
Spreading your risk among different asset classes is the logic of asset allocation, and why you should maintain a broad exposure to a variety of investments. Read my article on “Why Is Asset Allocation Important” for more details on the strategy.
“TERRIBLE” NEWS! If…
On the other extreme, someone who has just retired and has insufficient liquid reserves should be nervous. If a recent retiree does not have sufficient money set aside in liquid accounts (e.g., Money market funds) to cover at least 1 year of living expenses, they could be forced to sell stocks during this downturn. The resulting impact (called “Sequence Of Return Risk”) can be tremendously detrimental to their retirement income outlook. It’s EXTREMELY important as a retiree to avoid the need to sell stocks during a downturn. For more details, read Strategy #6 from my article “7 Strategies To Make Your Money Last Through Retirement” for information on how to utilize a “bucket strategy” to protect yourself in retirement.
“JUST” NEWS! If…
For everybody else, this is just news. Markets go up and down. Always have, always will. Benefit from that reality. How?
First: If you’re still working, dollar cost average your way into the market. This means buying the same dollar amount, every month. As prices go down, you’re buying more shares. As prices go up, you buy fewer shares. An example will clarify:
Using that example, you’d end up with 15 shares at an average price of $13.33 ($200 invested / 15 shares = $13.33). Why? Because you bought more shares when they were less expensive.
I’ve been dollar cost averaging for 30 years via my 401(k) at work, as well as through automatic transfers from my bank account to after-tax joint accounts in (primarily) Vanguard. It gives me some peace of mind, during market downturns, to know that I’m buying “more” shares for the same monthly investment.
Second: make sure you’re watching your Asset Allocation, and take advantage of “corrections” to gradually adjust your asset allocation if you’re off target.
Question 2: What Am I Doing With My Investments Today?
I’m soon to be 53 years old, and only a few years from retirement, God willing. I’ve got an investment portfolio that I’ve built over 30 years of steady contributions, which has taken a hit from the current correction. A bit nervous? Sure. But only a bit.
As mentioned above, I’ve written several articles about market volatility, including “4 Ways To Reduce Worry In Today’s Volatile Market” and “What Me, Worry” (including 10 tips to managing market volatility). Now, it’s been time to take my own advice.
Here are 5 specific steps I’ve taken since Dec 31:
Two: I updated my “Love Letter” to my wife, including updated financials, passwords, etc., to reflect changes made during 2015.
Three: After completing #1, I compared our current Asset Allocation to our Target. (for the record, I’m intentionally carrying a bit of excess “cash”, since I’ve felt the market was over-heated and have sold some positions over the past year to lock in the gains. In hindsight, it appears to have been a good move).
Four: I updated our financial plan. I recognized the variance between “target” and “actual” allocation, and have identified moves I’d like to make over the coming year to adjust back to “target”. I’ve identified which mutual funds I’d like to buy, in which accounts (IRA vs. Roth vs. After-Tax). While “cash” may give peace of mind, it’s a terrible strategy for retirement. A retirement portfolio must keep pace with inflation, and that’s impossible with cash (especially in today’s low interest rate environment).
Five: Since we’re “under-weight” stocks and “over-weight” cash, I’ve moved small amounts from cash into stocks on each major down day. I expect this downturn may last a while, so I’m “dripping in” cash on the way down. I don’t want to miss the downturn if it turns out to be only a minor blip (e.g., like Aug in the chart at the top of this post), but I also don’t want to invest too early only to watch the downturn turn into a bloodbath. Difficult balance, so I’ve decided on the “drip” approach. Yesterday the market was down 2%, and I executed a trade to move a bit of cash into Vanguard’s Global Small Cap Value and Vanguard’s Dividend Growth funds. Last week, I moved a bit into Vanguard’s USA Small Cap fund. I’m also targeted to grow my Emerging Market exposure. I have a bit of a high risk tolerance, and am NOT making any recommendations to my reader – just sharing the moves I’m making in our personal account. We’ll see how this turns out, as hindsight is always 20-20. For now, that’s the plan.
Finally, we’ll maintain a cash reserve. Given our relatively short timeframe to retirement, we will continue to hold a minimum of 2 years of living expenses in cash after our re-allocation adjustments. On Day 1 of retirement, we want to know we could leave any asset untouched for at least 2 years in the event this turns into a major bear market, requiring several years to recover. In the event of a Japanese-style “lost decade”, we’ll have to rethink our plans, but I’m counting on the fact that markets have always recovered after downturns, regardless of how bloody that downturn may have been.
The Bottom Line: Recognize market volatility will always be with us. Have a plan, and execute on that plan when the market presents an opportunity.