After ending the year with a major market drop, it's natural to wonder how to react and how to avoid over-reacting. We'll discuss what you should consider to help keep your portfolio strong for the long run.
1. Avoid Making Impulsive Decisions
In this article we’ll be referring to the Standard & Poor’s (S&P) 500 Index, which is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies by market value. Another common U.S. stock market benchmark is the Dow Jones Industrial Average (DJIA).
As the S&P 500 plunged 19.8 percent in late September 2018 to the brink of a bear market1, our firm encouraged investors to remain steadfast and not panic. Clearly corporate earnings were slowing2 but based on historical patterns we didn’t believe a recession was imminent. Managing emotions during times of increased volatility, such as we experienced at the end of 2018, is what can be a good investment strategy and difficult for most investors. Avoiding buying high and selling low requires investors to keep their emotions in check and do the opposite of what our emotions are telling us to do which is to “take action” even if that action doesn’t result in a better outcome. It may just feel better that we did something.
2. Diversify Your Portfolio
Diversified portfolios are designed to weather the ups and downs of the markets. So when the markets are down no action may be required. It can be difficult to remain committed to a diversified portfolio when the market drops and that is precisely when we believe we need to do just that. Fundamentally the equity (stock based) side of the portfolio will rise and fall much more than the fixed income (bond/cash) side of your portfolio. The bonds in a diversified portfolio are designed to add the steadying factor during the down equity periods and give us a tool to buy or sell to rebalance or provide liquidity if needed. For example if you need money from your portfolio when equity markets are down we can typically sell a portion of your bond allocation without selling at a loss since they often retain their value when equity markets are down.
3. Understand How the Stock Market and the Economy are Different
We often talk to our clients about the difference between the stock market and the economy. The stock market is often thought of as what is happening to indices like the S&P 500 or the DJIA. They are designed as a proxy for what is happening in segments of the US stock markets. Daily we hear about the movement of these indices and it is easy to start thinking that as these indices move so moves the economy, which may not be the case.
What is important to remember about these indices is that they are informational tools telling us about the emotion of those invested in the investments underlying the index. They are not a direct reflection of the economy. For example, if the DJIA drops 3 percent in one day it may be due to an emotional reaction to some news of the day, when nothing in the economy had likely fundamentally changed from the day before.
4. Separate the Economy from the Stock Markets
The business cycle, which is a measure of the economy, is typically based on the rise and fall of production of good and services in an economy. It is generally measured using gross domestic product (GDP). The cycle is comprised of four periods, expansion, peak, contraction and trough. We believe the business cycle achieved peak growth in the 2nd quarter of 2018 when it hit 4.2 percent3 and the transition and progress through an economic slowing phase, contraction, has likely begun. Without more unseen shocks, we believe it appears that the economic expansion can continue but at the decreasing rate. Volatility in the markets is common in the contraction stage of the business cycle but it doesn’t define how much longer the cycle may take to come full circle. In 2018, we have likely moved from peak to contraction. Historically the remaining time on an economic cycle has varied from months to years. Even though we are past the peak of the business cycle there are still positive indicators giving some tail wind to our economy.
One of the big drivers of our US economy is consumer spending. As consumers feel more confident about the economy, jobs and our expectations for the future we typically buy more goods. Consumer spending is a large factor of our GDP and according to Adobe Analytics, 2018 Cyber Monday sales made it the single largest shopping day in US history. We believe tax cuts for both individuals and corporations in 2018 may be helping to offset some of the drag on the economy from uncertainly coming from government shut downs to geopolitical issues.
Although economic factors, such as fear that the Federal Reserve may not navigate the interest rates in the coming year as well as what is going on with our government may impact our economy, it can be helpful to separate the economy from the markets and our emotions from investing. As financial advisors the most difficult and most impactful advice we can give our clients is how to understand your own emotions as they are impacting your money and investing decisions. We all bring our own money stories and beliefs to our financial lives. It’s your advisor’s job to know your history and to understand what is important to you to help you achieve your goals and give you the best advice we can to navigate the opportunities and pitfalls that are unique to you.
Sources:
1 Source: Seeking Alpha https://seekingalpha.com/article/4231735-s-and-p-500-verge-bear-market
2 Source: Market Watch https://www.marketwatch.com/story/this-trend-threatens-one-of-the-stock-markets-strongest-pillars-2018-09-26
3 Source: Bureau of Economic Analysis U.S. Department of Commerce https://www.bea.gov/news/2018/gross-domestic-product-3rd-quarter-2018-third-estimate-corporate-profits-3rd-quarter-2018
All Financial products have an element of risk and may experience loss. Past performance does not indicate future returns. There are no assurances that a portfolio or investment will match or exceed any particular benchmark.
