The 531-point drop in the Dow Jones industrial average Friday (Aug. 21) was certainly headline grabbing in its magnitude. It represented a one-day 3.1 percent drop in the index and resulted in a 10 percent correction from its high in May.
It’s completely natural during such times for your stomach to churn with worry about how this will impact your wealth and how you should react. With that in mind, I want to share a couple of thoughts behind the approach you should be taking with your investments.
• Higher returns come with greater volatility. There is no free lunch in the financial markets. In order to achieve the investment growth needed to support most people’s desired lifestyle in retirement, some exposure to higher return-producing asset classes such as stocks is necessary. It may help to recognize that there have been 35 U.S. stock market declines of 10 percent or more since 1900 and five world stock market declines of 20 percent or more since 1970.
Despite this, markets (and investor wealth) have still grown significantly after those periods. Most recently, since its low in 2009 the U.S. market has climbed more than 160 percent through Friday. Seen in that context, the recent negative performance is just a small drop in the bucket. But gaining the higher returns associated with stock investing is dependent on being disciplined through both good times and bad.
• Market timing does not work. It’s tempting to want to be able to sell before the market drops. Unfortunately, no one has been able to identify any reliable way to do it. Imagine if there were such an indicator. In an efficient market (such as the U.S. stock market), all participants would be able to see it and would react at the same time. In order for you to be able to avoid the drop, you’d need to be able to react to that indicator faster than everyone else. Not only is that extremely difficult, but you’d also then be faced with the decision as to when to get back into the market, again before everyone else does. How would it be possible for you to make these kinds of decisions consistently and correctly? Try it yourself.
• Diversification reduces volatility. The primary reason your portfolio is diversified across a number of different asset classes is to reduce its volatility. And it works. Not only can this be explained mathematically (I will not do so here), but Modern Portfolio Theory even explains how appropriate diversification can improve your overall portfolio return as well. Was your portfolio down as much as 3.1 percent after Friday’s plunge? Probably not. Of course, we don’t know how your investments will perform in the next few weeks or months, but you can be sure that diversification will take the sting out of any sharp declines in any one particular asset class in which you are invested.
• Downturns provide buying opportunities. U.S. stock prices are now on average 10 percent cheaper than they were in May. Although most of you probably have no need for any portfolio adjustments at this time, if you have been maintaining a very conservative allocation you may be in a position to shift more to stocks to take advantage of what you can think of as “sale prices.” This is not to say that stock prices are currently cheap, even after the recent drop. But they are a relative bargain as compared to the week prior.
• The media is not your advisor. As I’ve said many times before, the media’s role is not to educate you. Rather, it is to play upon your emotions with the goal of getting you to read or watch what they have to say. You would do well to ignore much of what you are hearing and focus instead on your longer-term investing goals.
Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, call 209-4062 or email [email protected].
