Stock Market Corrections Remind Us of Fundamental Lessons of Investing

We’re about 1 month into the equity market correction, signaled by the S&P 500 dropping 10% from all-time high levels in July of 2015. After experiencing 4 years of relatively consistent, positive performance out of US stocks, investors are now being reminded of some fundamental lessons they all should know.

In my prior blog post, I wrote about the performance of the S&P 500 over the past 4 years, producing very strong returns over that time period. If you’d invested in a proxy for the index on the worst day in 2011 (July 18, 2011, the day it hit near term highs before starting to go down in value) and still held it today after recent pullbacks you’d have experienced about a 41% gain since 2011. That’s an average annual return of approximately 9% compounded. This is pretty well in-line with long-term growth expectations of the US Equity markets as measured by the S&P 500.

There are some basic ideas that most investors either know, or need to know. I try to share some of these ideas with clients when they first become clients, and remind them of these principles throughout the time we are working together. I’ve found that whenever we experience a period of contraction in the equity markets, whether it’s a bull market correction period or during a bear market, the principles need to be revisited. Further, whenever we go through extended periods of growth these same principles often get forgotten.

Here are the basics of these principles:

1. Markets go up, markets go down, markets go up again. There are ebbs and flows to financial markets. Pricing is based on supply and demand in the short term, but based on underlying fundamentals in the long-term. There are times that supply or demand can change and cause short-term changes in financial market pricing and there are times that the underlying fundamentals change and we see a little longer interruption in financial market growth. In either case, over enough time, markets will go up. Every time there has been a correction in the past and every time there has been a bear market in the past, the markets have moved on and eventually set new highs again.

2. Diversification is critical. If for no other reason, diversification helps cushion the impact of asset price fluctations. If an investor is solely invested in 1 stock, they ride the wave of what the pricing of that 1 stock goes through. If an investor is invested in just large-cap US stocks, they are more diversified than owning just one stock but still will experience portfolio value fluctuations consistent with the movements of the broader markets. My belief is that investors should have a balance of stock investments (large and small companies, foreign and domestic), bonds, and alternative investments. By blending investment types into an investment portfolio, and investor is able to reduce risk and volatility and sometimes able to add portfolio return by achieving returns in some parts of the portfolio when other parts are contracting or idling.

3. Avoid emotional decision making. It’s hard to separate emotions from financial decisions. We tend to operate with the emotions of fear and/or greed when we allow our emotions to guide our financial decisions. Fear is usually more powerful than greed. Both can lead an investor in the wrong direction. Making investment and financial decisions that are logical and practical will be much more successful than decisisions based on emotions.

4. “This time is different” are the 4 most dangerous words to an investor. We can usually draw wisdom from the past. While the details might be different from things we’ve experienced before, the principles remain the same.

5. Stay disciplined, my friend. It’s important to understand why you are investing, what your goals are and have a strategy and allocation that matches those goals. Find a strategy that works and stick with it. Market ups and downs are just noise. An investor has to keep focused on what’s important to them and not allow themselves to be guided by things that draw their attention away from it.

6. Buy low, sell high. Often times investors are tempted to pull away from the markets when we experience market pullbacks. This approach is flawed. There are 2 ways to make money investing: collecting dividends and interest payments from our holdings, and buying assets at prices lower than what we sell them for at a future date. Too often investors will want to sell their investments when they go down in value (typically driven by fear). If we believe that markets will go up again over time, which I do, then a more logical response to a pricing pullback would be to buy more. But at the very least, it most often prudent to stay on track with your investment plan and do go off course because of short-term interruptions in the trajectory of prices.

All of these ideas, along with some others, can provide a good basis for guiding your investment principles. The day-to-day, week-to-week, month-to-month movements of market pricing will have little impact on the long-term outcomes of your investment strategies if you stick with your principles and stick with your plans. It’s important to not get blinded by short term trends, whether they are positive or negative. Keeping realistic expectations in focus will help an investor stay on track and avoid making decisions that can ultimately cost them years worth of investment returns. Remember, no one can time the market perfectly and investors really shouldn’t try. Trying to “invest” by timing the market and jumping in and out to try to avoid short term market volatility is more like gambling than investing. Investing involves buying quality and hanging on to it. It involves a little bit of faith that markets work over time. It involves patience. It involves discipline. It involves understanding.

Finally, I’ll conclude by saying that I think most investors can benefit from having an advisor. As an advisor, many times my role goes far beyond recommending an allocation and the specific investments to fill that allocatoion. Quite often I act as a counselor to my clients. Perhaps the greatest value that I provide clients is being a voice of reason and being a buffer between their emotions and their money. When things are going well in the market, most people don’t put much thought into their portfolio because they don’t really need to. A high tide raises all ships. It's when we experience market volatility that most investors start to pay attention. My role in those times is usually to remind them of the conversations about why they’re investing to begin with. And to remind them of these principles that will help them stay on track so they can participate when the markets start to move upward again.