My Favorite Rollercoaster – The Stock Market

 

The last couple of weeks have seen breathtaking volatility in the stock market – not all that different from the kind of volatility produced by a roller coaster at Six Flags.  Most asset classes are showing negative returns for 2018, and the riskiest segments – such as small cap and emerging market stocks – have lost more than 20% from their recent highs. 

 

A close peek at the chart below shows that intra-year declines have averaged 14% since 1980.  You can see that most of the time a market correction of 10% or more does not turn into a Bear Market, defined as a loss of 20% or more.  While many individual investors might be tempted to sell stocks in the face of declines because it seems like you’re taking control of the situation, this is likely only an illusion.  Most of the time, once a market is in correction territory much of the bad news is in the rear-view mirror. 

 
© J.P. Morgan

© J.P. Morgan

 

But this misses the main point.  Which is, if you are not a forced seller, you don’t have to sell.  A wise investor once said that the market is there to serve you, not to inform you.   

The market is off its highs.  Stocks are on sale!  Just because they might get cheaper should not discourage you from investing, and surely a correction shouldn’t scare you out of them if you were already investing (odds are that you owned them at this price before but weren’t panicking when they were rising through today’s price level).   

Let’s think about a simple example.  If a $35,000 car you were eyeballing suddenly but temporarily became marked down to $28,000, you might think about snapping it up.  If the dealer became even more irrational and sold his last to your neighbor for $25,000, you might be upset with moving too fast, but you still got a deal and shouldn’t be upset with your purchase.  After all, they’ll soon be selling again for $35,000 (or more).   

Market volatility is a short-term risk but the real risk to most investors is the long-term failure to meet your future consumption needs.  And stocks do a great job protecting you against this risk if you own them through thick and thin and find ways to ignore the short-term news (I suggest turning off CNBC, which cares more about drawing in eyeballs than in helping you manage your portfolio. Rick Santelli does not know what your portfolio looks like or what you’re trying to accomplish with your investing goals). 

Now, if you need cash for a specific purpose in the next five years, it shouldn’t be in the stock market.  If you have bonds, you can use those to provide you with liquidity until the market bounces back.  Also, your stocks and bonds are throwing off cash flow every day in the form of dividends and interest, which can also help with cash flow.  Keep your eyes focused on your cash flow, not the market.  You can’t control the latter.   

If you don’t need cash, you have the option of taking advantage of the market’s crazy volatility.  You can afford to take advantage of cheaper prices but should know that they could always become cheaper.  If you can’t afford to let that happen because you’ll need the cash soon, you shouldn’t be investing, even if you believe it’s very likely the market’s next move will be up.  

No one has a crystal ball, so you should never guess what the market might do.  Here’s what you can know – your cash flow needs.  And you can design a plan around those.  Focus on what you can control – your behavior.  Review your reasons for saving.  Know your goals.  And their time horizon.  If they’re shorter than five years, have some bonds.  If you can’t stomach volatility, have some bonds.  But know that you can’t have it all…you must encounter sweaty palms from time to time in order to grow your wealth.  It’s because of the unsettling feeling associated with stock market volatility which provides them with the higher returns needed to compound wealth over time. You’re simply exchanging your psychological, short-term feelings for a real-world, long-term benefit. 

The Johnston Group employs a disciplined process to manage your portfolio through uncertainty, and our focus remains on producing a growing stream of cash flow, which is much more controllable than market performance.  While the market appeared oversold earlier this week, we don’t recommend chasing stocks on the upside or throwing the baby out with the bathwater on the downside.  Reality is never as good or as bad as it looks!  We anticipate that there will be more corrections and even bear markets along the way (as has always been the case).  We just can’t tell you when they’ll occur.  But we know they will not throw a well-designed plan off course.  We can and will respond to them as they occur in ways which will neither hurt, but could often help, your long-run performance. 

As a final point, we’d like to state that bear markets usually happen when something is fundamentally wrong with the economy, which does not appear to be the case here.  Portfolio diversification won’t mitigate all the downside, but it certainly helps.  Know that much of the turbulence has already happened.  Don’t get off the rollercoaster in the middle of the ride.  The stock market has always recovered from corrections and bear markets.  Every single time.