I am being inundated with new headlines about market declines and volatility. The last time I wrote about this topic was in 2016. Since that time, the S&P has increased by almost 50% even factoring in the bear market losses we have seen this year. During the last six years, we have experienced declines of greater than 10% four times (in December 2018, March 2020, February 2022 & June 2022).
Each time we experience a market downturn, it feels unprecedented. However, historically, market downturns have happened with surprising frequency. Not only are we in a downturn, it would be unrealistic to think we would not experience future downturns.
That said, it can be uncomfortable to see your assets decline in value. Here is a brief explanation of the psychology behind the reaction to market cycles and some recommendations to help you navigate discomfort.
Psychology and Behavior During These Times
Researchers see a pattern in our behavior during these cycles. In a bear market, like we are in now, investors have a strong aversion to loss, which research has shown is twice as painful as a gain is pleasurable. These feelings make it hard to let go of negative events with persistent worries about another downturn or recession. Procrastination sets in and makes it hard to get into the market or to invest more, at a time when the opportunity may be the greatest.
As the stock market starts to bounce back, the bad memories start to fade. Headlines about stock growth, cause us to then want to take action when stocks have already risen. At this stage, “investors view the last bear market as a one-time aberration, blamed on a housing bubble or a financial crisis,” says Jim Stack, of InvesTech Research in this article. They believe that everything is now under control. We then believe stocks will continue to rise, because that has been the recent trend. As the downturn then comes again, the most recent market top becomes our target point that investors believe they need to reach in order to sell their shares, and the cycle begins again.
Actions You Can Take Now
- Reference a long-term chart of the stock market to help you maintain historical perspective.
While this is the 11th U.S. bear market since 1950, duration and outcomes vary widely, but stocks generally have performed well over the next 12 months. (A bear market is defined as a drop of 20% off its highest level.)
Historically, over the long term, since 1926, a portfolio with 100% stocks provided an average annual return over 12% while a 100% bond portfolio was over 6%.
This is not the time to be changing your long term strategy or to consider getting out of the market. This is easier said than done. Normal market cycles can stir up your emotions and push you to invest unwisely, but being aware of your behavioral biases can help you focus on your long-term plan.
Resist the urge to check your balances daily. Monthly statements are more than ample timeframes to get a peek at your performance.
- Determine an asset allocation that is both diversified and appropriate to your risk tolerance and stage in life, and then rebalance on schedule, no matter what the market is doing.
Given your feelings during this time of market downturn, you may want to reconsider the level of risk you are willing to take. It is important to note that the impact of market volatility is dependent upon the stock and bond percentage within your portfolio. Stocks (and stock funds) tend to be impacted the most by changes in the market, but they also have the potential for higher returns. Whereas, cash and bonds trade off higher returns for less risk. This can be adjusted over time so that you are not selling at an inopportune time.
- Build up cash reserves and pad your emergency fund.
Typically three to six months of living expenses in cash are recommended in case you need it for unexpected expenses or a job loss. This will allow you not to be reliant on long term investments in the near term, which you want to avoid when there is a market decline. In other words an emergency fund can help you ride out market downturns when they happen. If you are in or close to retirement, keep enough cash to cover one to three years of living expenses so you can spend your cash instead of pulling from investments that have decreased.
If you’re saving for a long-term goal (such as eventual retirement), dollar-cost average by investing a fixed amount on a regular schedule.
In other words, automate your investing. This takes the emotion out of buying and lowers your average cost per share.
Long Term Success
These strategies are critical to building a foundation for your long term investing and financial success. Market downturns are normal and will continue to happen over time. My aim is that this information helps you prepare for them and experience them with less angst.
Image courtesy of: Dana Sredojevic