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Earlier this summer, I blogged about a potential market correction, and it seems in recent weeks that correction has arrived.  Other recent blogs talking through the woes in Greece and potential struggles in China and other pockets of the world help go into more detail as to some of the precursors that led to this recent decline.

While we know the stock market can be a rollercoaster, the last several days through Tuesday’s close have felt like one long downhill ride.  At one point just five minutes after Monday’s opening bell, the Dow Jones Industrial Average lost 1,089 points from where it closed on Friday, a day that saw that same index lose more than 500 points.

It’s well known that we believe that neither we nor anyone else has the ability to know when major market moves are coming.  While that knowledge helps form our view of markets, how we invest and our expectation for inevitable market volatility, it doesn’t feel any better or less frightening when those moments arrive.

Grab the Maalox, Rolaids or whatever gets you through these typical, but painful moments and let’s look at some of this more closely.

What’s Happened

There’s no one reason why corrections like this occur, but no matter the set of reasons, they all tie back to uncertainty.  Companies in markets all around the world are priced at any given moment based on everything known at that time.  It’s when the unexpected happens that high levels of volatility appear.

Uncertainty in China, plunging commodity prices, their impact on the energy sector and when the Fed might make a move on interest rates are the primary culprits in the most recent downturn.  Any of these points could cause concern, but as with most things in the market, the interrelated nature of all of these and many, many more contributing factors make for a well seasoned correction stew.

China continues to struggle to maintain breakneck growth through increasingly free market practices under the tight control of a communist state.  As their ability to control this slowdown has come into question, their markets have been sent into a tailspin.  Monday alone saw the Shanghai Composite Index down 8.49%.

When the largest population on Earth goes into recession, demand for many commodities, in turn, goes down.  This is on top of an oil supply that far outpaces demand already putting pressure on commodity and energy markets for some time now.

This type of volatility is why we keep exposure to emerging markets low and stay out of commodities entirely.  Emerging markets can offer generous returns in the long run, but the short term volatility is such that exposure should be kept to a minimum for the average investor.  As for commodities, it’s tough to find any historic argument that the inflation adjusted returns offered by this asset class are worth the inherent risk and volatility.

Correction Psychology

We intuitively know that markets fluctuate like this.  In fact, it’s normal.  In these moments, that’s the last thing we want to hear, but it doesn’t make it any less true.

There is a lot of psychology that goes into why we react to market movements, both up and down, in ways that contradict our stated plans and goals.  Decisions made when cooler heads are prevailing and intuition more sound give way to our brains desire to go into some kind of primal survival mode.  Wall Street Journal contributor Jason Zweig wrote a great piece on Monday describing the Psychology of the 1,000 Point Drop and why events like this make us prone to miss the big picture.

Take emerging markets, one of the asset classes at the root of this recent event.  Yes, it’s down sharply, but that’s hardly news.  Returns for the MSCI Emerging Markets Index over just the last 15 years range in any one year between -53.18% and +66.42%.  And that’s for a calendar year.  Within a given year, swings can be even wilder.

It’s the most volatile asset class we invest in because it also represents the highest expected return over the long run.  We want to participate in that, but mitigate the risk by only having it represent a small part of portfolios.

Even with a less volatile index, like the S&P 500, we find a similar tale.  Since 1980, the S&P 500 has dropped more than 14% on average at some point during any given year, yet the index has finished positive 28 out of those 34 years.

Correction Planning

As New York Times’ Your Money columnist and author, Ron Lieber opened in an excellent article this past Friday, “The impulse when the stock market falls hard for a few days in a row is to do something.  Anything. ”  He goes onto explain why this is precisely the wrong thing to do.

So, what is TAAG doing during these tumultuous days in the market?

We build client portfolios based on a client’s specific goals and ability to tolerate risk.  We invest in the stock market to the extent necessary to achieve these goals.  The rest is invested in cash and short term, high quality bonds to help portfolios and plans weather these types of market storms.

If a client is still accumulating wealth and saving towards retirement, this is an excellent time to invest built up cash or rebalance out of bonds that have increased in value and invest in some of the poorer performing stock funds.

For clients that rely on their portfolios for income, we maintain sufficient balances in cash and bonds to ride out these down cycles and not be forced to sell stocks at an inopportune time.  In the event that cash and bond balances exist out of balance with our target, we use these opportunities to rebalance into stock funds at lower prices.

Regardless of where a client falls along this spectrum, we continually monitor accounts on an individual basis for opportunities appropriate to that client’s specific needs.  It’s this customized, individualized approach that allows us to know we’re doing the right thing for the individual or family as opposed to making blanket decisions or following rules of thumb that may not and often do not apply to all.

As always, we are here to talk through how any and all of this applies to your specific situation.  If you have questions about current market conditions, how they impact your investments or, more importantly, your long term planning, please let us know.  We’ll continue to monitor for rebalancing opportunities, communicating what’s going on in markets in plain English and working towards our goal of meeting your goals.

Have a great week!