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What to Do When the Market Tanks

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It was a Monday morning in the fall of 1987. I was young software engineer immersed in a technical project. The older guys in the office were talking about a crash in the stock market. It would become known as “Black Monday” — the largest one-day percentage decline in the Dow Jones Industrial Average (DJIA) in history. That sounded scary. But, I didn’t own any stock. And I had a job to do. So, I got back to work. As it turned out, the economy was hardly affected, and the DJIA regained its previous high a little over a year later….

It was early in 2000. The Internet was a game changer, and we were all thrilled by dot-com stocks. Though the bulk of my retirement money was safe in a 401K and low-cost mutual funds, I played around with a few thousand dollars in high-tech IPOs. I fancied myself a bit of an expert in software. I quadrupled one holding. I must know what I was doing! Finally, the market peaked in early March. I watched my gains drop back to zero, and ultimately sold most of my positions for small losses. Meanwhile the bulk of my retirement savings, in those low-cost mutual funds, kept growing quietly in the background….

It was the summer of 2008. I checked the DJIA on my cell phone. Down again. Though we didn’t know it at the time, the Great Recession had started. My hoped-for early retirement would be out of the question now. What should I do? I was a savvy investor. I had cash on hand. So, over that long, depressing summer and frightening fall, I rebalanced monthly. But, by the end of 2008, I was out of gunpowder and out of courage. The market continued downward, with the DJIA losing more than 50% of its value. In March 2009, near the bottom, I doubled my 401K contribution. That was “long term” money and I could stomach the risk. Gradually the market started growing again. And my investments during the dark days accelerated my portfolio’s recovery. My net worth regained its former level about a year later. And, after another year, in April 2011, I retired….

That was the start of a long bull market. One that continues today. Or does it?

The Latest News

On Wednesday, August 19, the Dow Jones Industrial Average closed at 17,349, well within its trading range for most of the past year. But, by the next Tuesday, August 25, it was at 15,666. That represented about a 10% drop in the broad market for stocks. Last week the Dow closed at 16,102, representing about a 7% drop from the status quo on August 19.

As of the close last Friday, my investment portfolio had dropped about 3% from when I last valued it in late July. Since our asset allocation is less than 50% stocks, that makes sense. My portfolio is not nearly as volatile as the entire market.

Supposedly, the Chinese devaluation and subsequent fears for global growth triggered this latest market drop. Given the aged bull market, some observers think we’re seeing the beginning of the next economic slowdown. Then, at the start of this week, the DJIA staged a triple-digit rally, based on hopes for Chinese stimulus. But it’s all a soap opera of short-term thinking. None of it matters much for long-term retirement planning….

And, what I’m doing about it? Nothing. I did everything I could do to be prepared for most stock market eventualities many years ago….

Maintaining Perspective

“If you believe the stock market may not come back this time, then you have much more to worry about than your investment portfolio.” –Rick Ferri

In virtually every historical study, and in most future projections, stocks outperform other asset classes by at least several percentage points over the long haul. That’s as sure a bet as we get in modern financial life. But owning stocks feels scary at times.

Volatility, corrections, and bear markets are unavoidable. They are an inseparable part of the investing process. If you want to grow your money over the long haul by owning stocks, then you must accept volatility, corrections and bear markets as inevitable.

The real “news,” if any, is that we’ve gone so long without a major market fallback. The current decline is a relatively small percent of the ongoing bull market, one of the longest in history. As a serious, long-term investor, you must be prepared for a decline of 50% in stocks, at any time!

But, a 50% decline doesn’t mean you’ve lost half your money. Unless you panic. To avoid that, here’s a critical investing habit: Ignore how much cash you could trade your entire portfolio for on any given day. That’s a distracting statistic. Retirees don’t need to sell their entire portfolio at a single point in time!

According to Charles Schwab, over the past 50 years, the average length of a bear market has been a little over one year, and the average time for the market to recover and reach its previous highs has been less than four years.

Since the length of the average retirement or career is many times the length of the average market downturn, it’s foolish to lose sleep just because stocks are down for a few years. As long you own some other asset classes that behave differently from stocks, odds are that your portfolio can withstand routine market gyrations.

What Should You Have Already Done?

If you’re panicking at this recent, relatively modest decline, then you’ve learned something valuable about yourself: You know that your tolerance for risk is lower than your current portfolio reflects. You need to be holding less in stocks and more in bonds and cash.

It’s hard to overestimate the importance of a cash/bond cushion for your financial security and peace of mind. Especially in retirement, you need enough cash and bonds to outlast the average bear market and eliminate any reasonable possibility of having to sell equities at a loss. According to Schwab, that would mean holding at least four years of living expenses in cash and bonds. Personally, I have much more than that.

Cash is simple, but loses out to inflation over the long haul. Bonds are the traditional counterweight to stocks, likely to keep up with inflation, but introducing some volatility in your portfolio. If you’re an experienced investor, you could also hold assets like international stocks, real estate, or commodities that are not always strongly correlated with U.S. stocks. Uncorrelated assets should hold their value better when stocks are down.

If you’re still working, then you need to invest on a schedule. Regular withdrawals from your paycheck are the simplest approach. Retirement and financial independence are too important to leave as an afterthought. And, when you invest regularly, down markets are good news! You don’t have to make a conscious decision to buy stocks on sale. You take advantage of “dollar cost averaging” — buying more shares when prices are lower. Your investment program harnesses the volatility for you, automatically.

What Should You Do Now?

“Your long term results are less the result of how well you pick assets than how well you stay the course during the bad periods.” –William Bernstein

A major market downturn is one of the worst times to take action on your portfolio. Unless you’ve just realized that your risk tolerance doesn’t match your asset allocation, the best advice is “do nothing.” If you absolutely can’t resist making a move, make it a very small one as a “test.” I’ll admit I’ve made a few 1% portfolio moves in the face of major market shifts. This made me feel better, for a while, and it was educational. But it was never a savvy investment decision. More often than not, I would have been better off leaving my holdings alone….

Investment advisors like to advocate for rebalancing. It’s an argument for their professional services. But, as I’ve explored in my series of articles on rebalancing, the benefits are probably overblown. Beware the perils of rebalancing too quickly. That’s just active trading by another name. Most major market shifts take months, if not years, to play out. In 2008, I rebalanced in the early months of the downturn, when I probably should have waited another year. As long as your asset allocation lies in a broad range reflecting your risk tolerance, patience is advised.

You can increase the odds for wise financial behavior by reducing or eliminating the flood of financial information. Don’t check your portfolio constantly. I review mine weekly, but frankly, that’s too often. I want the historical data, and I can generally trust myself not to react to the news. But I don’t recommend that level of attention for the casual investor. When I was on the road this summer, I ignored the stock market for a month. I “missed” the initial downturn, but I didn’t miss any actionable information.

A meltdown in the stock market is a test, but it’s not the final exam. There is one thing you can do, but it involves thinking, not trading. A major drop is an opportunity to evaluate your asset allocation and your investing behavior under real-world conditions. Monitor your aversion to risk, and decide whether your portfolio truly reflects that. You can’t eliminate emotion in investing. But you can choose to act instead based on logic and a long-term financial plan. Game on!