Stock market routs are dangerous, not simply because of their immediate impact on your portfolio, but also because of the long-term damage to your psyche.
Allowing this bear market to scare you out of stocks does more harm than the actual sell-off. Missing the 10 best days of a stock market’s performance, for instance, is costly.
But sell-offs present not just danger, but opportunity.
On Feb. 23 I wrote: “When stocks begin their inevitable slide … increase your contribution level to your 401(k). It simply makes sense to buy more of something when it is cheaper. You can dial your contribution back once the market rallies if you must, but you will have used the weakness to increase your purchasing power.”
I hope you did. Because though we didn’t yet know it, the market had already topped.
Now stocks have rallied significantly off their lows. But remember, if we were to look back at the eight previous bear markets the first rally is always followed by a drawdown — and it averages about 10.3%. So don’t be surprised if stocks decline again.
Have a plan
The best mitigation strategy for dangerous times is to have a plan. Presumably, you established your current 401(k) allocation with some thought about your risk tolerance and return objectives. And it is also likely you set those allocations in happier times. Now is the perfect time to reevaluate your plan.
If you have a three-to-five-year time horizon, which most of us do, (even if you are retired) make sure you are taking enough risk. Despite the always present threat of a bear market sell-off, stocks from 1926 through 2018 averaged 10% to 11% annually.
Understand the risk
The hardest thing for any investor – whether lay or professional – is to know when to trim winners. By nature, we tend to want to hang on to what has just worked. It’s called the recency effect and explains why investors often ride investments up and then back down.
Take the popular bond index, the Bloomberg Barclays US Aggregate, which reflects the performance of investment-grade, U.S. dollar-denominated bonds. If you are lucky enough to have some portion of your 401(k) exposed to bonds, you are well aware that they have not only likely produced a positive return, but in the case of the Bloomberg Barclays, a return of just under 5%.
We tend to rate bonds as low risk. Yet, rates are now at historic lows and the future risk to your portfolio may actually reside in an overweight to bonds where yields from the very shortest maturity to the longest are negative after inflation.
According to an article posted on morningstar.com by Michael Schramm, “If rates move up by 1 percentage point, the price of a bond with a duration of 5.0 years will move down by 5%, while a bond with a duration of 10.0 years will move down by about 10%.”
Make sure you are taking enough risk.
Time in the market is key
Long-time horizons provide investors with the opportunity to produce returns. If you are a 401(k) investor your time horizon should be long, even if you are retired, because you are unlikely to need your entire 401(k) balance all at once. Resist the temptation to sell during downdrafts. If at all possible, commit new cash. And trim back your winners and add to new funds or companies that are on sale.
I like to think of retirement as 20 years of unemployment (or longer if you are lucky!). Consequently, you want your nest egg to continue to grow.
Stephanie Mucha (the subject of a previous column) began her investing career in earnest during retirement, on a fixed income, and died a multimillionaire.
That, my friends, is the ultimate opportunity market sell-offs provide.