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Don’t Get ‘Boiled’

9626724_sI was in our Plymouth office this past Saturday meeting with Bob and Cindy. They are a nice couple, ages 65 and 62, respectively, and were seeking financial advice. They both want to retire in about two to three years. Bob said that while their portfolio is almost back from when it dropped in August, he is very concerned about when they stop working. Bob went on to ask a very direct and pointed question. “What is the difference between a market correction and a bear market and how would each impact our retirement?” He further explained to me that when he asked his current broker this question, he didn’t really get an answer and was just told that they must “hang in there” for the long haul.
 
Hmm . . . this guy is 65 and his wife is 62, what exactly is that long haul?
 
I explained to Bob and Cindy that after the volatility in August, many people are wondering the same thing. So first, let me review with you, Cutter Family Finance readers, what I explained to them, the difference between a bear market and a correction. That is the easy part.
 
When broad market indexes drop by 20 percent or more, many consider this as entry into a bear market. Bear markets often occur over a period of at least a couple of months. On the other hand, a correction has occurred if there is a 10 percent drop in those market indexes. Historically, most stock market corrections are shorter in duration than bull markets.
 
While these definitions provide a clear-cut line in the sand, it is important to understand why it can be dangerous to pay too much attention to these measures.
I have no idea who picked 10 percent and 20 percent as the official lines in the sand that define a correction and a bear market. But oftentimes, these defined terms tend to give investors false confidence if the numbers support the premise that the markets are not officially either in a “correction” or a “bear market.” In fact, some investors who cannot afford a loss of 20 percent or more are often told to hold on to their stocks and mutual funds until the markets enter a bear market. That advice can be simply, well, reckless.
 
Look, as it stands now, the S&P 500 is not in “bear” territory, at least as defined by the mainstream financial world. Actually, it is only about 5 to 6 percent below its market highs, nowhere close to the 20 percent line in the sand. But as I explained to Bob and Cindy, to end the discussion there or to base an investment strategy on that fact is not very wise.
 
Folks, here is what you need to know. Of the individual stocks that make up the S&P 500, 35 percent have dropped at least 20 percent in value. And get this, another 27 percent of them have dropped 10 to 20 percent from their highs.
 
Here is my point: when you consider that nearly two-thirds of the S&P 500 is in bear market territory or quickly approaching it, it is hard to take comfort from the fact that the S&P 500, as an index, has not yet dropped enough to meet the mainstream financial world’s definition of a bear market. This false sense of security creates a dangerous situation for the typical long-term investor, who is likely being told to “hang in there” until we can officially call a bear market.
 
With Bob and Cindy, I used the parable of the “Boiled Frog” to make my point. Suppose you want to boil a frog. How do you do it? You could place the frog into a pot of hot water, but as soon as it feels the heat, it will jump out. So, what can you do? Put a pot of cool water on the stove and then add the frog. Not sensing danger, the frog will stay in the pot. Next, turn the burner on low to slowly heat the water. As the water warms, the frog relaxes. The warmth feels good. As the water gets hotter it acts like a steam bath draining away energy and deepening the frog’s relaxation. The frog becomes sleepy and has less energy as the water gets hotter and hotter. By the time the frog realizes its danger, the water is beginning to boil, and it is too late to take action. There is neither time nor energy left to do anything. The frog perishes in the boiling water.
 
What is the moral of the story? Don’t let unexpected change creep up on you. Don’t become a “boiled frog.” Pay close attention to what is going on around you, so that you can notice when the “water” is getting hot. Knowing far enough in advance that change is on the way allows you to make plans. Knowing that change is on the horizon allows you to take advantage of opportunities, rather than chance being unexpectedly beset by a crisis. At their ages, Bob and Cindy’s investment strategy cannot be to “just hang in there.” I asked them to ask themselves what their “long haul” is. And I ask you, Cutter Family Finance readers, “What’s yours?”
 
Don’t wait until it is too late to act. Always be looking ahead. Don’t allow yourself to become complacent. Don’t become a boiled frog.
 
Be vigilant and stay alert because you deserve more.