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Avoiding an Irrational Response to Irrational Markets

February 27, 2020
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We seemed to be headed for a positive return in February as of just last week.  But in the last few days, concerns about the global economy growing much slower than originally anticipated in 2020, and possibly not growing at all, has caused stock prices to fall dramatically as we search for clarity around the impact of the coronavirus in China and increasingly in other parts of the world.  

The headlines and resulting concerns of a viral outbreak like coronavirus, much like the SARS virus about 15 years ago, can be scary.  But it's important not to make important, long-term financial decisions based on these short-term emotions.   This is easier said than done when you see stock prices falling precipitiously.  Our natural urge is to sell and lock in the prices we can get before they go lower.  

Rooted in this urge is a sense that stock prices are behaving erratically, falling haphazardly and without reason.  But that's rarely the case.  Stock prices change continuously, every day, to reflect the most up-to-date information we have about the future growth prospects of the underlying companies.  When a dangerous viral outbreak, for example, results in quarantines that threaten to temporarily reduce the amount of goods and services that companies will be able to sell, it is assumed that this will reduce future earnings.  Stock prices logically have to fall to reflect this new possibility--less profitable companies should have lower prices.  If our concerns about a slowdown turn out to be overdone, prices will have to rise just as quickly to reflect the surprising new, rosier expectations.  The important takeaway is that current prices, all of the time, reflect everything we currently know and expect about the future.  Only new (future) news, which by definition no one is in possession of, will affect future prices.

After a year like 2019, where markets were relatively calm and most asset classes had above-average gains, we tend to forget how volatile returns can be.  The chart below lists the annual returns on the US stock market between 1979 and 2019.  Despite the fact that stocks had positive returns in over 75% of the years and averaged over 10% per year, there is a considerable amount of volatility from month to month.  On average, every year, stocks fall by over -14% from a previous peak.  In some years, as the chart shows, the decline can be worse (up to -50%), in some years it's not as severe.  But declines do happen every year.  Sometimes the price peak is on January 1st, meaning the year gets off to a difficult start.  In other years we see gains of +10% or +20% before stocks temporarily lose ground later in the year.  While the coronavirus is a unique risk we haven't had to deal with before, the market's response to this concern--a temporary decline--is similar to other issues of the past.

If we step back from the week-to-week or month-to-month returns of stocks, clear trends emerge.  Stocks occasionally lose -10%, -20%, -30%, even -40% or -50%.  But these temporary bear markets tend to be short lived and rather infrequent.  The bull markets that propel stocks higher in the long run are more frequent and much more pronounced.

The fact remains, the catalyst for many of these temporary declines are never-before-seen events that threaten the prospects for economic growth and sometimes, our personal safety.  In the throes of a panic or scary situation, it can be hard to stay optimistic and believe that things will work out.  Historically, however, a diversified investment portfolio has weathered some of the worst conditions we've experienced and generated positive returns despite the fears and uncertainty.  It's easy for us to forget all of the issues we have dealt with in the past, and how resilient our investment portfolios have been.   

With all this in mind, you might still find yourself asking: Why not take some money out of stocks before I lose even more ground?  Maybe I could get back in at a lower price, avoid the losses, and earn even more as your ride the eventual recovery back up?  Unfortunately, there's no clear indicator for when stocks will fall, we only know that they've gone down thus far.  The odds, even after a loss of -10% or more, is that stock prices will be higher in the future.  Consider the returns on the S&P 500 since 1926 in the one-, three-, and five-year periods after a stretch where they've declined by -10%.  The average subsequent one/three/five-year return on the S&P 500 is about +10%, which is the same annual return that we see over all one-, three-, and five-year periods!  This means that the market has no memory--the future expected return on stocks is about +10% a year, regardless if we've recently gained or lost value in prior months.  If you bail out now, the odds are not that you'll be able to get back in at a lower price, but by the time you get back in prices will be higher and you'll have lost money by missing out on unexpected gains.

Ultimately, one of the keys to a successful investment experience is avoiding irrational decisions during periods of seemingly irrational market behavior.  

  • Knowing why stock prices move the way they do can help reduce concerns on days when markets are making extreme moves.  
  • Learning to expect wide swings in short-term stock prices as a normal course of events can help desensitize us to their impacts.  
  • Remembering that diversified portfolios have been able to weather many historical crises and generate consistently positive intermediate and long-term gains can provide you the confidence that sticking to your portfolio usually makes the most sense.  
  • Realizing that historically, even after markets have dropped dramatically, by -10% or more, future returns have still been reliably positive and similar to all future periods of time can help you resist the urge to want to sell to avoid potential future losses.

Most of all, however, it's important to always stay focused on the big picture.  You're not a day trader--you have important retirement, ongoing cash flow, and legacy/charitable goals and your investment portfolio is well designed to accomplish these things over the course of your lifetime.  There will always be uncertainties and regular setbacks.  But by focusing on the things we can control and ignoring or tuning out those things which we don't have any impact on, the chances that you will be happier and financially more successful is much greater.  

If you have any questions or concerns, as always, don't hesitate to reach out for a chat.

--EN

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