Sticking to Your Investment Policy Through Market Corrections

Unfortunately, the market continues to dish out unwelcome news for all of us. As I have said often, market corrections are the pain that investors must suffer in order to achieve good long term returns. This is the essence of capitalism. Why would a capitalistic economy reward someone for taking no risk, or for enduring no uncertainty? Of course, it won’t.

But sticking to your investment policy through normal market corrections is critical. Those who pick an investment policy - and then waffle on it in hopes of avoiding that pain - underperform. It’s as simple as that.

TONS of data supports this observation, not the least of which is DALBAR's annual Quantitative Analysis of Investor Behavior which seeks to quantify just how much investors lose when they "waffle." How much? About 2.89% average annual return. That's nearly the difference between investors who earn a long term average of 4% versus 7%.

Well… that’s not very much, you might say. But consider the power of compounding - at 7%, a million dollars grows to almost $2 Million dollars in 10 years (1,967,151).

At 4%, a million dollars grows to only 1.48 Million. That's an AWFUL lot of money to miss out on just to be "comfortable."

So... yes, this market correction is tough and the media are throwing all sorts of prognostications out left and right and I read most of them. But the DATA does not suggest recession is imminent, and things aren't as scary as they were in 2012, when the market corrected a LOT more, after which the 2013 market rocketed to a 32% return and new all-time highs in the middle of a GLOBAL recession (which, fortunately, the US didn't take part in).

2012 was SCARY if you were paying attention. The economic world was going to end as we knew it. US debt skyrocketing, the Fed’s printing of money left and right was going to cause hyperinflation, the government was going to shut down (it didn't in 2012, but it did later in 2013), oil prices were at historically high levels ($111 per barrel) and we were surely going to slide into the "double dip" recession.

RecessionAlert and our other recession algorithms said, "Bunk." But boy, it was scary.

And just like that, in 2013 the market rocketed 32% to new highs.

Similarly, in late 2015 and early 2016, we had awful "doldrums" in the markets where we got nothing but horrible corrections and the markets went nowhere. And there were the prognostications of recession... but our DATA said "nope." And then... just like that, 54% gains in the S&P 500 over the next 2 years.

Will all this happen again? I don't know. But I do know that currently, NONE of our recession algorithms are predicting imminent recession. So, in general, our advice remains unchanged. Maintain your investment policy that you previously decided was right for you – at least until the market has recovered. As of this writing, we are nowhere near the 20% market correction that we all know could happen anytime, which is what we all train for, and at PARAGON, what we design portfolios for. Hang in there and try to think about something else.

  • Could the market drop more? Yes. Will it? I don't know. Maybe.

  • Could it get worse? Yes, it could.

  • Could we have a Santa Claus Rally? Yes. Does it happen all the time? Nope.

  • Is China falling into Recession? Maybe. Or... they could be reporting soft economic data (i.e., lying) to get better trade deals. I don't know.

  • Will Brexit cause a lot of fallout? Probably. Is that factored into the market already? I hope so.

  • Will the Fed continue to raise interest rates? Probably. Is that factored into the market already? Probably. But they've been acting dovish lately, so they might back off. It might be a nice surprise, but the market could also interpret a dovish Fed as economic weakness, and respond… unfavorably.

Government Shutdown? 

There may be a government shutdown. Fortunately, we DO have some data on how markets have behaved during previous shutdowns. 

According to a recent CNN article, there have been a total of 18 government shutdowns, starting with 1976 and ending with the last one in 2013.  I was able to quickly chart the last 4 of these… enough to draw the conclusion that market drops are not necessarily a guaranteed result of a government shutdown.

  • Oct 6-8 1990 market down 6% was back by the 22nd, up another 5% by the end of the year.

  • Nov 14-18th market up 0.8%

  • Dec 16, 1995 – Jan 5, 1996: Market down 4% but mostly AFTER January 5th 1996. Roared back over 8% to all time high by mid  February.

  • Oct 1-16, 2013: Market down 2.4% but bounced back by the 12th, 4 days before end of shutdown, rocketed up 12% by end of year.  

So... trying to do trading around government shutdowns is random at best. Really random, with literally no predictable market behavior at all. But one thing's for sure - it would increase trading costs and likely have tax impacts that mean giving REAL money to Uncle Sam to avoid temporary paper losses.

The reality is that sometimes the market tests our resolve.  All we DO know from nearly a hundred years of stock market data is that markets don't generally drop more than 20% without a recession, that markets typically bounce back within 4-6 months (often faster), and that investors who make changes DURING a correction almost always underperform. 

Hang in there! To quote the great philosopher Bill Clinton, "I feel your pain." (And yes, I really, really do since I'm a relatively aggressive investor myself...)

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Jonathan Darabos