The Dow, S&P, and pretty much every major index have dropped approximately 6 percentage points in two business days. Do you need to take action? Here’s how to think about it with data, charts, and mentions of cake.
It’s been an exciting few days in the stock market. By exciting, I mean terrifying and a little like contracting the stomach flu – painful and engendering hopes that it will pass soon with as little damage as possible.
Nearly everyone I know is talking about the 6% plunge we’ve seen in the past two days. It can be terrifying to watch your hard-earned nest egg shrink by thousands of dollars overnight, thousands that might take you months or years to “earn back.” The natural question I’ve been hearing from folks is, “Do I cut my losses? Do I sell?”
My answer is no. And I’d like to show you why as well as suggest a more productive set of actions for your time.
The Investing Thesis
In times of unrest, the single most helpful thing you can do is go back to your investment thesis and take comfort in reviewing whether everything still holds. As an institutional investor, this is first line mental defense #1. For those who’ve read through the investing archives of the blog, you already know my thesis for investing in the stock market is a long-term play based on performance data specifically over long-term ranges (read: 10+ years). You can read a more fulsome outline of why I think low cost index funds are one of the highest performing bets you can make, but here’s the gist of it:
Long-Term Stock Market Returns
The compound annual growth rate of the S&P 500 from 1950 to 2016 was 11.27%. Nice. Would love to make anywhere near that type of return long-term on my money.
And what about the downside? If you look at every 10-year period of returns from 1926-2014:
- Only 5 out of 80 periods show a compound annual growth rate (CAGR) of less than 0%
- The median CAGR is 9.78%
- The worst 10-year period yielded a CAGR of -1.38%. Obviously not ideal to be making no money over 10 years, but if the absolutely worst, most atrocious historical scenario was roughly equivalent to stuffing your money in a mattress, it’s hardly a horror story.
Source: All Financial Matters
This key performance data – the long-term rate as well as the 10-year rolling historical averages, particularly on the downside – show me that the risk to reward ratio is very good for making a bed on the stock market.
The thesis I am betting on, then, is that I may not know exactly which years the market will do well and which it will do poorly, I think the next 10 years we are going to have conditions that are at least comparable to the conditions we saw from 1926-2014 if not on the better end compared to past periods. So it’s worth buying stock index funds.
The conditions in past periods include such terrible periods as the Great Depression, the dot com bubble, and the subprime housing crisis. It’s comforting to know even in periods that include dire events such as those that the worst CAGR was -1.38%.
Current Events: How Reporters Explain The Dip
Let’s bring ourselves back to today. The stock market is down 6% in two business days. Has anything about my thesis changed? As I read articles covering the plunge, there’s not a single shred of evidence to suggest my thesis is broken. Here’s what financial reporters are attributing the drop to:
- Potential concern about inflation ramping up. Okay, but owning stocks is a natural hedge for inflation since the businesses selling products into the economy will increase prices to keep up with inflation, which are then reflected in their earnings.
- Potential concern that interest rates will rise and the era of easy money for businesses will end. This looks to be true; the Fed has not been shy about signalling its intent to raise interest rates. But let’s not forget that that’s a good sign for businesses in that the Fed feels the economy and demand for goods is strong enough they can finally inch rates back up. Borrowing money may get more expensive for them, but the Fed only plans to raise rates if the economy and thus demand for companies’ goods is relatively stable/strong. In past quarters when signs haven’t looked strong, they’ve backed off planned interest rate increases until they saw signs of strength. We can probably expect the same going forward.
There’s also the very real possibility that no one actually knows why the stock market has dipped. In any case, I see no new macroeconomic shift that would cause me to reconsider my bet on the grounds that some key factor will disconnect future performance from that of the past 92 years in a hugely negative way.
That means the challenge you and I are dealing with right now is emotional rather than fundamental.
Framing: How To Deal With The Emotional Rollercoaster
Dealing with an emotional challenge requires a whole different toolset than dealing with a fundamental analysis issue. Everyone has their own method for coping. I prefer copious amounts of baked goods (but I’m pregnant, so really I’ll take any excuse for cake).
If you’d rather not employ that tactic to get through the day, you may find it helpful to reframe today’s “frightening/terrifying/unprecedented plunge” against a larger backdrop. For example, this is probably the time window you’re using to look at what’s happened:
Ahh! Terror! Panic!
But this is how the full past year of performance has looked:
You lucky son of a gun. You’re still up 15.3% in a single year? I’m feeling less sorry for you. In fact, you’ve done well enough you can afford to buy me a drink.
And how about the 5-year view? Here’s what that looks like:
Unprecedented, huh? 5 dips of similar scale in the past five years, almost one each year. And those drops were of similar scale but off a smaller base at the time, meaning they were likely larger percentage drops than the one we saw over the past two days. By the way, your 5-year CAGR despite those 5 blips? 11.7%. Hmm, watch that angst just melt away.
The broader 5-year view helps us see that while this is an unpleasant blip, it is not necessarily an unusual or concerning development.
I of course can’t guarantee that it is benign, and I encourage everyone to keep tabs on market news in case it unearths something that truly does affect the fundamental thesis around buying stock funds. for the long-term But the point is that that time has not yet come.
Now is not the time to sell your stocks and hide your money under a rock. But I do have a suggestion for where you can apply all that nervous energy.
What To Do Instead of Selling All Your Stocks
Buy More Stocks
Instead of selling your stocks, you might consider taking the opportunity to buy stocks on potential discount. As you look at the natural peaks and dips that have taken place over the past 5 years, this may in fact be a nice local minimum which you can take advantage of. Bonuses for many folks come between December and March. Perhaps this is the cash infusion you can use to pick up an additional position.
Reevaluate Your Investment Allocations
If it has been difficult to stomach the recent 6% plunge, you may be taking on more risk than you’re comfortable with. Very often our allocations between stocks, bonds, and other asset classes was set very early on in our careers with little forethought, and have grown haphazardly since.
I think it’s incredibly important to pick an allocation that allows you to sleep well at night, and it’s far simpler than you think to pick the right allocation for your stage of life. I encourage you to check out the primer in the link above to make sure you’re efficiently set up to get the most gains at a risk level that’s right for you. And if like most people you are a little rusty on what exactly your allocation currently is, I highly encourage you to correct that by adding a dashboard that allows you to see your finances and investments easily. You improve what you measure, and this sort of data should be quickly at your fingertips so you can remain nimble with your decisions. I use a free service called Personal Capital which allows you to track your net worth and expenses. You can check it out below and see if it’s for you.
Explore Lower Volatility Investments Like Income-Generating Real Estate
Another option to consider if today’s contraction was an unpleasant reminder to you is to evaluate other asset classes outside of the usual stock and bond funds. I’m particular enthusiastic about real estate, particularly income-generating properties. Even during the subprime crisis in which home values plunged as much as 30%, you would have been hard-pressed to find the rent rolls of properties decreasing at all. Most properties were still commanding the typical 1-3% annual rent increase. The weak markets saw no rent increase or at most a 1-2% decrease. Income-generating properties were able to ride out literally the worst thing to basically ever happen to the housing market and basically emerge unscathed if you didn’t have to sell for liquidity.
Some markets are still underwater compared to pre-2008 prices, but the math on an income-generating property may not actually incur a loss if the property is meant to be held for income (like a bond) and the owner can afford to be patient and choose his own maturity date unlike an actual bond (i.e. sell the home when the market is healthy enough).
As an early retiree, I find this risk and volatility profile intriguing. Expect to see more articles about analyzing rental income properties. But for now I’ll caveat that opportunities are hyperlocal.
It’s perfectly natural to feel some anxiety when the market dips, but hopefully the frameworks above help you evaluate the situation with a cool head and determine whether there are fundamental flaws in your thesis that involve an action to sell or whether you simply need some emotional (read: baked goods) support to get through the tough time.
How are you handling the volatility in the markets? What do you think about the situation?