A recent article in USA Today described the market volatility we’ve experienced since August of last year as proof that we’re living in a new paradigm; one in which we will no longer experience positive stock market returns without market corrections.
Who said it was possible to invest in stocks without experiencing corrections?
From the summer of 2007 until the spring of 2009, the daily drops and dives of the stock market put many people in the emotional state of believing that they would never again benefit from investing in stocks. This belief caused many people to shift more of their portfolios into bonds and cash, while others gave up on stocks entirely.
The Great Recession that caused some to abandon stocks was followed by 1,326 calendar days without a drop of 10% or more in the S&P 500, which is the ‘correction-free’ investment period referred to in the article. But it isn’t possible to experience positive returns in stocks over your lifetime without experiencing sometimes painful corrections as well.
To some people this may sound like boring investment advice recycled when markets drop. But it’s a fundamental truth that has to be embraced in order to be a successful investor.
Whether you’re 36, 56 or 76, you need to have a clear plan for investing in stocks that makes sense for your personal financial situation. You’ve heard us say – many times – that you need to have a financial plan to deal with the emotional pull of the market, but what does that mean? At the minimum, you need to answer three fundamental questions before you invest, in order to be emotionally equipped to stay invested through volatile times, and keep yourself from bailing when things get rough:
What are your cash needs?
If you need a down payment to buy a house, are paying tuition bills, or have short-term health care costs that need to be covered, you should have adequate funds set aside in cash. It’s not healthy checking your smart phone constantly, worrying that another drop in the market is going to keep you from meeting your financial commitments.
If you rely on your investments to provide your retirement ‘paycheck’ each month, you should have enough set aside in cash and short-term, high credit-quality bonds to cover your needs for the next 5 or so years, to prevent you from being forced to sell your stock holdings when they may be down significantly.
The Personal Finance 101 rule about keeping 3 -6 months of living expenses in cash for emergencies felt like a waste of funds when the market was on a streak and interest rates are nearly nonexistent. But an emergency cash account is the foundation for your peace of mind when things are rocky.
What does your money need to do for you?
Once you’ve covered your cash needs, you need to consider your other objectives.
Every investment dollar you accumulate should be earmarked to accomplish something, and each task will likely have a different time frame and resulting investment objective. It’s critical to make this distinction when we invest, because ‘making as much as I possibly can’ is not a goal that can ever be reached, and as a result it creates emotional stress and the temptation to react in ways that will sabotage your savings, in both good times and bad.
When markets become rocky, we have a tendency to think in much shorter time frames. It’s difficult to believe that daily losses won’t continue for the long term, and what we have built up won’t be taken away.
But events like retirement don’t begin and end with our official retirement date; it’s a 30 years or more journey for many people, and the long-term growth that stocks have provided since the early 1900’s is necessary for your savings to last for the rest of your lifetime. Other objectives, like leaving a legacy for a charity or your family, require a longer term outlook as well.
Being specific about what you want to accomplish helps you put a more solid plan in place, and allows you to respond to negative market changes in ways that can benefit you in the future.
What can you tolerate emotionally?
We regularly test our clients for their ability to handle drops in the market, and supplement this with conversations about how they’ve handled past experiences and challenges with investing.
Ignoring your feelings about risk and investing heavily in stocks because someone’s latest economic or market outlook report recommends it is like playing ‘chicken’ with your emotions. You may feel compelled to run away from stocks at the worst possible moment.
Measuring your tolerance for losses with a risk questionnaire doesn’t solve everything, but it gives you a framework for determining how much of your investment holdings should be placed in stocks, and how you may react during the next Great Recession.
There is no such thing as correction-free investing.
Preparing for days like these – in advance- helps you live your life, doing the things you want to do, without obsessing over the latest doom and gloom headlines.