Be Calm When Markets Are Not
Today’s unexpected vote by U.K. citizens to exit the European Union (EU) has resulted in stock market turmoil worldwide. Unsurprisingly European stocks have taken a beating. U.K. stocks dropped over 3%, German stocks over 6%, and in France the CAC-40 plunged over 8%. Even the Japanese Nikkei fell over 7%, its worst single-day performance in five years, most likely due to expectations that currency investors will flock to the yen for safety, driving up its price and consequently negatively impacting the profits of Japanese exporters. In the U.S., the S&P 500 closed down 3.6%. On the positive side, U.S. and U.K. stocks were up almost 2% for the first four days of this week, while French and German stocks had already climbed over 7%. So this week’s net losses are actually relatively small (except for Japan). At the same time U.S. government bonds rallied, as did gold, as investors flocked to those perceived safe-havens. With a well-diversified portfolio you should not be seeing any large losses as a result of today’s market performance.
You are likely wondering when the markets will settle down. The answer, as always, is that nobody knows. Britain’s exit from the EU will play out slowly over a number of months, and along the way it will variously impact the earnings of companies across different sectors of stock markets worldwide. But stock prices will inevitably rise whenever the expectation of company growth returns. Every so often there’s some event that spooks the markets. Last year it was China, and the year before it was Greece. As with those downturns, a few years from now today’s sell-off will most likely be remembered as a footnote in stock market history.
I want to additionally remind and reassure everyone that your financial success is based not on the size of your investment portfolio at any given point in time but rather on the degree to which that portfolio will support over time all the future goals in your financial plan. While those of you with more conservative investment strategies will experience less of a downturn today than those taking a more aggressive approach, in either case if you have created a plan that passes multiple stress tests, you should remain confident that even with a temporary drop in the value of your investments, you are likely to be fine over time.
At times like this it helps to review the key ideas behind the investment strategy you are following. Here are mine:
- Higher returns come with higher 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 thirty-five U.S. stock market declines of 10% or more since 1900 and five world stock market declines of 20% 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 nearly 200%. Seen in that context, today’s 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, you’d then be faced with the decision as to when to get back into the market, again before everyone else does. How easy do you think it would be to be able to make these kinds of decisions consistently and correctly? Try it yourself at the following site: http://www.getrichslowly.org/blog/2014/02/04/what-is-market-timing-and-should-you-do-it/.
- Diversification reduces volatility.
The primary reason your portfolio is diversified across a number of different asset classes is to reduce its volatility. 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. Although stocks fell today, bonds gained. That’s diversification at work. 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.
Stock prices worldwide are now cheaper than they were a week ago. If you are still working and saving money, you’ll be able to buy shares at lower prices with your savings, resulting in higher growth in the future. Even if you are retired, you still need to grow your portfolio, and downturns represent opportunities to shift money from lower-growth bonds to higher-growth stocks.
- The media is not your advisor.
As I’ve said many times before, the media’s role is not to educate you. It is rather to play upon your emotions with the goal of getting you to read or watch what they have to say. A great example is the current presidential political campaign, in which the candidates getting the most coverage are not the ones providing thoughtful explanations of proposed policies or beliefs but rather those that make the most controversial bombastic statements.
I remind you that during times like these it is important to stay calm and refrain from making decisions that may be detrimental to your long term goals. If you are not yet retired, this current downturn should have very little impact on your future. Even if you are currently retired, a good distribution allocation plan should help insulate you from the need to sell any assets at steep losses.
Markets will go up and down many times throughout the rest of our lives. Proper financial planning should allow you to enjoy your life and ignore the bumps along the way.