Stocks Crashed! What Do We Do Now?
Warning Order
In the past two weeks, we have seen the largest single-day points drop in the history of the Dow Jones Industrial Average. We have also seen several days where the DJIA has traded in a range of over 1,000 points, levels almost unheard of. With markets in the red for 2018, many people are feeling the urge to do something about it. We have to do something, right? Well… maybe not. The recent correction and wild volatility likely have several causes which we can’t control. What we can control, though, is our plan and our behavior.
Situation
The last two weeks have been the most volatile markets in recent memory and, from a points perspective, the most volatile in history. The recent 1,000-point swings in the Dow Jones Industrial Average follow nearly two years of relatively steady growth in U.S. and world stock markets. Stocks are officially in correction mode, defined as a 10% drop from recent highs and many investors are wondering what to do next. We must do something right? If we get out now, we can avoid the fall and buy back in when stocks start going up, right? In both cases: probably not.
So what caused this this correction in stock prices? Some point to rising bond interest rates, others inflation, and others to people realizing that stocks are just plain overvalued. Does anyone really know for sure? Nope.
For decades, investment theory has operated under the variations of the efficient market theory. One of the primary assumptions of the theory is that stock prices rapidly adjust to new information. Recent price changes have certainly been rapid, but what new information do we have about the U.S. and world economies? Nothing significant has changed from three weeks ago.
Another field examining investment theory is called behavioral finance. Some of the concepts have been known for a while, but the field has only started receiving more formal recognition recently, culminating in the award of the Nobel Prize in 2017. Behavioral finance suggests that investment prices can be inefficient due to investor biases. The particulars of behavioral finance are for another time but can be summarized with the saying “markets can remain irrational for longer than you can remain solvent.”
Coordinating Instructions
Accepting that markets are not always efficient, we can return to our current conundrum: what to do about the current correction. Here is what we know: the world economy is growing, stocks are at least 10% below their highs, and they are much higher than they were one year ago. We don’t know where they will be in a month or at the end of the year. However, we are confident that stocks offer the best opportunity for return for a diversified investment over the long-term. Plenty of data supports that expectation.
As a group, investors tend to disagree with the buy-and-hold perspective and try to time the market with the goal of better returns and/or avoiding decline. The opposite happens, though. An organization named DALBAR conducts an analysis of investor behavior and associated performance. Updated each year, the study consistently indicates that investors, on average, underperform their selected investments. Over the 20 years ending in 2016, stock investors earned a 4.79% annual return while the S&P 500 had an annual return of 7.68%. The 3% underperformance is mostly due to attempts at market timing. While discussing market timing, the authors state, “investors lack the patience and long-term vision to stay invested” and “jumping into and out of investments […] is not a prudent strategy because investors are simply unable to correctly time when to make such moves.” The results are similar across all time horizons.
Since we can’t reliably predict what stocks will do in the short-term, we should focus on our financial plan. Has it changed? If it hasn’t changed, investments shouldn’t change. Why sell long-term investments based on market changes that occur in a two-week period? There isn’t a good reason. I have no doubt that you will be successful if you stick to the plan.
Command & Signal
The recent market correction is a new experience for some investors. Without a correction since early 2016, even experienced investors have forgotten what it feels like to have the value of their accounts go down. It’s tempting to look for deeper meaning and determine the course of events over the next few months, but evidence suggests that selling to prevent further declines unlikely to improve long-term returns. In fact, it’s normally a losing proposition. Stick to your plan; stick to your investments.