One thing I love about Cape Cod is being able to see the water. The ocean is constantly changing and constantly in motion. Waves build, crest, and break. The same thing happens with the stock market. After a historically long climb, the Dow Jones Industrial Average (DJIA), as of this writing, finally hit a bump last week and sank over 1,000 points on Monday, February 5th, setting off a chain of market reactions around the globe. Throughout the week the market continued to be volatile as prices rose and dropped depending on the day.
The latest market downturn got started as Wall Street traders voiced concerns over inflation, following a jobs report that showed a spike in wage growth. A big selloff in risk-parity funds and algorithmic trading done automatically by computer amplified that chaos. Traders who sold futures on the Cboe Volatility Index, or VIX, got hit the worst.
Despite this, it’s important to remember that underlying economic fundamentals remain stable. What’s more, we’ve been experiencing a record period of low volatility and stocks have been trading at historically high levels from January 2017 to January 2018.
It looked like Tuesday was going to be another rough day: the Dow sank more than 500 points when it opened. But once investors got their wits about them and realized things weren’t as bad as they thought, the Dow roared back, gaining over 500 points on the day.
This is one of those cases where what’s happening on Wall Street isn’t indicative of what’s happening on Main Street. It’s also one of those cases where what’s happening on Wall Street isn’t necessarily what’s happening on all of Wall Street – the Dow is an index of just thirty major companies, not of the entire stock market.
We’ve been in a bull market since 2009. Since then, we’ve had four official corrections – a correction is defined as a 10% decline in the market. We’ve also had dozens of little blips since then when it looked like the market was headed for a correction, but it straightened itself out.
The recent decline was the biggest single-day point drop in the Dow’s history, and that was the headline story on the evening news. What the news did not report is that there have been larger single-day drops, when calculated in terms of percentages. But as they say in the news business, “If it bleeds, it leads.” News outlets will always chase the most dramatic story they can, even if facts and data don’t bear out the hysteria.
The point is this: market volatility is to be expected. Weeks like this make me remember that old English proverb in the headline, “Smooth seas never made skillful sailors.” We prove our mettle when we are met with adversity, either on the water or in the stock market.
Even though we’ve been through a period of sustained growth and very low volatility, it’s important to remember that this period of calm sailing has been the deviation, rather than the norm. As we look at the market’s history, we realize that corrections happen almost annually. Financial analysts will tell you they’re healthy and necessary for the market. In fact, they argue, sometimes those corrections can create new investment opportunities and can push momentum upward.
In fact, since 1945, the S&P 500 has had a decline of 5-10% 77 times, a 10-20% decline 27 times, and a 20-40% decline 8 times.
Hmmm . . . educated investors understand this.
They know that the market rises and falls, just like the tide on the beach. Educated investors have a long-term strategy and fix their gaze on their long-term goals, not on temporary market disruptions. The educated investor understands the risk associated with their investment strategy. This is why it’s so important to have a financial system in place: One that you can follow in times of market turbulence and one that minimizes your downside risk.
On the ocean, heavy weather sailing requires experience and preparation. Having the right tools at your disposal, the knowledge of where to go, and the discipline to know what to do can mean the difference between life and death when the weather gets rough. The same principles apply to investing.
Understanding risk mitigation will help you avoid becoming that emotional investor because periods of market volatility will test your investment strategy, which is why you need a sound one. And although many folks want a sound strategy, they don’t know what questions to ask to implement one that will work for them. When looking at your existing investment strategy, or considering a new one, you must ask yourself the following questions:
- How has it behaved through a full market cycle? (Historically, five to eight years).
- What are the downside risk triggers? Are there any?
- How did it fare the last time the market entered a significant downturn, like in 2008?
- Historically, what was the maximum drawdown, or “swing” in the strategy?
- Is your current risk mitigation system consistent with your financial goals?
Keep in mind that risk may not be eliminated entirely from your investment strategy without resorting to very low-yield investments. And remember that risk is neither good nor bad, but each investor has an expectation of what is an appropriate amount of risk based on his or her unique goals and needs. Understanding the risks associated with your investments can give you a better sense of whether your strategy is consistent with your long-term goals and needs.
There are different methods that can be used to assess the risk in your investment strategy and volatility can be measured and compared to a benchmark index, like the S&P 500. Examining a portfolio’s risk-adjusted return can give insight into its overall performance, as well.
Folks, educated investors understand the historical behavior of their investment systems. This information helps prevent them from becoming emotional investors who sell and buy at the worst possible times. Shouldn’t you, Cutter Family Finance readers, understand your system, so that you too, can create a sound investment strategy? One that can weather the bad times and tack under full sail when seas are calm.
Be vigilant and stay alert because you deserve more.
Have a great week.
Jeff Cutter, CPA/PFS is President at Cutter Financial Group, LLC. A wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Jeff can be reached at email@example.com
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