How to Thrive During a Market Correction
How to Thrive During a Market Correction
As the great investor Peter Lynch noted, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
As discussed by Morgan Housel in The Psychology of Money, consider what would happen if you saved $1 every month from 1900 to 2019. You could invest that $1 into the U.S. stock market every month, rain or shine. No matter if economists are screaming about a looming recession or a new bear market. You just keep investing. Let’s call an investor who does this Sue. But maybe investing during a recession is too scary. So perhaps you invest your $1 in the stock market when the economy is not in a recession, sell everything when it’s in a recession, and save your monthly dollar in cash. You then invest everything back into the stock market when the recession ends. We’ll call this investor Jim. Or perhaps it takes a few months for a recession to scare you out, and then it takes a while to regain confidence before you get back in the market. You invest $1 in stocks when there’s no recession, sell six months after the recession begins, and invest back in six months after a recession ends. We will call you Tom. How much money would these three investors end up with over time?
Sue ends up with $435,551.
Jim has $257,386.
Sue wins by a mile. There were 1,428 months between 1900 and 2019. Just over 300 of them were during a recession. By keeping her cool during just the 22% of the time the economy was in or near a recession, Sue ends up with almost three-quarters more money than Jim or Tom. To give a more recent example: How you behaved as an investor during a few months in late 2008 and early 2009 will likely have more impact on your lifetime returns than everything you did from 2000 to 2008.
Important Points to Consider:
- Market declines of 10% - 20%, known as ‘corrections’, occur on average every year and a half or so. Some years have none, some have two or more.
- The average correction lasts around 5 months.
- Market corrections can happen quickly, without notice, and for completely unexpected reasons, regardless of financial commentators predicting them daily for years, or explaining why they occurred - after the fact.
- When Lynch referenced money lost in preparing for a correction, he is referring to those who are trying to time the market, for example holding unneeded cash for extended periods and missing an increase of 20% only to be ‘right’ by investing with the market down 10% from highs which you didn’t participate in along the way.
- This should not be confused with the concept preparing for an upcoming financial event, and to have a well thought out plan well ahead of that event.
Don’t time the market, time your cash needs: The best way to not get burned by a correction is to set aside any cash you need for the next 12 – 24 months (to pay your monthly expenses, a down payment on a home, to fund your annual RMDs, etc.). That way, when the correction occurs, you have already mitigated any risks by not having to sell stocks on weakness to cover near-term expenses/capital outlays.
- Once you have taken care of near-term needs through cash flow and/or cash set aside, then investment dollars in stocks are not needed for 12-24 months or longer. Since the average correction lasts under six months, you have plenty of cushion to let stocks rebound before needing to sell to take care of future needs. You will have a great margin of safety to get through the correction.
- For those with excess cash beyond near-term needs (or for those with a dividend reinvestment program), market corrections can be great opportunities to accumulate high-quality securities at lower prices. You will never pick an exact bottom, but you don’t need to in order to achieve your financial objectives over time. You just need to avoid big mistakes like selling at panic lows for capital you don’t need anytime soon (if you needed it, you should not have been in stocks to begin with).
For most, material market declines feel bad in the moment. But for those with a pre-set plan and who work with a rational, disciplined Financial Advisor, market corrections should at worse be a non-event, or better yet an opportunity to enhance future returns. Those who have not thought ahead about what they would do during an inevitable market correction are more likely to take action that ‘feels good’ in the moment (selling stocks to get the bleeding to stop, to feel in control). However, a few short months later those same actions will cause all sorts of heart (and wallet) ache when markets recover, and you realize you have committed the investing sin of buying high and selling low. Such mistakes can take years to make up for, so purchase your fire insurance during the rainy season, not once you smell the smoke.
We are here to discuss your particulars to make sure your assets are appropriately allocated so that you can achieve your near and long term goals regardless of current market conditions.