Don W. Promhouse
December 16, 2019
"Grasshopper" – The Financial Shaolin Monk
Bob and Eve, my fictitious investors for this story, watched the Dow (Dow Jones Industrial Average) fall 666 or roughly 2.5% on Friday February 2, 2018. Then it followed through with another decline of 1,175 or 4.6% on Monday February 5, 2018. Bob and Eve phoned Tuesday February 6, 2018 only to discover the Dow had risen 567 points of 2.33% They asked what was happening, because they haven't noticed this type of gyration for a long time. I said, "You're right, it's been a couple of years".
I explained that investment professionals have been anxiously waiting/predicting a market correction for some time, unfortunately no one is able to predict the trigger point. But on Friday morning February 2, 2018, the monthly U.S. job report showed that wages surged in January, representing the sharpest year-over-year gain since the recession in 2008/2009. That stoked concerns about higher inflation because as companies raise wages, they often raise prices and that translates to higher inflation. This is during a period when the Federal Reserve is already expected to raise short-term interest rates this year as the economy has broken out of its 2% targeted growth rate. With inflation worries comes the belief that the Federal Reserve will increase interest rates at a quicker pace. Higher borrowing rates can be a challenge for corporations over time as they want to borrow money to grow and it drives investors to bonds rather than stocks.
I said to Bob and Eve that, "to understand what this means, first you must understand a couple of definitions".
First off a "bull market" is defined as a financial market in which prices are rising or expected to rise. After the 2008 financial debacle the current bull market started March 9, 2009 at roughly 7,294 and peaked at the end of January 2018 at 26,342 a rise of 260%, with a slight correction of approximately 17% in mid-2011. "So what is a market correction and how frequent are they?" Bob asked.
A market correction is a reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a "bear market" or a recession, but can be a precursor to either. Stock market corrections are fairly frequent events. Over the longer term a 10% - 19% pullback in stock prices occurs about once a year depending on the index. Corrections also tend to be a relatively short-term phenomena. On average, a market correction lasts about three to four months. Anything more than a 20% decline is widely thought of as a "bear market". Bear markets tend to be longer than corrections. The last bear market started in 2008 and lasted 9 months with the Dow dropping 44% (in US dollar terms).
As of Monday evening (February 5th) when the Dow declined 1,175 it had already dropped 8.45% from its peak in late January. Although, at this point it doesn't even qualify as a correction. So if market corrections or market declines are fairly common, why do individual investors react negatively and panic to sell? Studies have shown, part of the problem is that the joy/pleasure you feel when your account raises is amplified twice as much as the pain felt when your account declines. Investors should know that investments fluctuate in value and it's impossible to time (with any consistency) their investments into or out of the markets.
The major problem, I told Bob and Eve, is that they should stop looking daily at their portfolios or the markets. The activity of always checking and highlighting your portfolio is detrimental to your health, as the likelihood of investors witnessing a negative return is far greater than that if you looked once a year. The only caveat is that your portfolio has to be well diversified and matched to your risk tolerance. We have taken the time to build a well-diversified portfolio for you and it's during these types of declines that we need to stick to the portfolio we have built and not make rash decisions to sell.