Four Fundamental Investment Principles in a Down Market

We are currently in the longest U.S. economic expansion in history going on 122 months. We have had 107 consecutive months of job growth and the unemployment rate of 3.7 percent sits around the lowest level since 1969. The stock market measured by the S&P 500, the stock market index that tracks the stocks of 500 large-cap U.S. companies, is up approximately 20 percent year to date and home values are up. The stock market also has its risks – it can be volatile in the short run.

I’m not predicting a market decline but it’s in best practice to always be prepared. September 15 marked the 11th anniversary of the bankruptcy of Lehman Brothers and the beginning of the Financial Crisis. Angst and fear of the stock market falling by half crushed some investors, yet the S&P 500 now stands near record highs and has increased 450 percent since the March 2009 lows. So, while the sun’s shining and the seas are relatively calm, let’s do a lifeboat drill and discuss four principles that can help you manage in times of market turmoil.

Fear Can Drive Decisions

Why do some people sell their stock investments when markets decline and duck for cover, then wait for a magical whistle to blow signaling the coast is clear and buy after markets rise – sell low, buy high? It’s because we hate losing. Daniel Kahneman, a Nobel Prize winning psychologist, introduced the loss aversion theory in which he explains that people fear the pain of loss more than they enjoy the gains. This means that shying away from investments that are bad for our financial health is part of our innate survival skills. But it’s not all bad. We cannot ignore our fears and emotions, however, we can recognize that they can impact our investment decision making process.

Market Declines are Part of Investing

The capital markets have shown a permanent upward trend interrupted temporarily by market declines. This is part of the natural cleansing process. The good news is that based on the S&P 500 since 1949, corrections (10 percent or more declines) and bear markets (20 percent or more) don’t last forever. Declines of five percent or more occur about three times a year and last about 44 days, 10 percent declines occur about once a year and last about 114 days, and 20 percent or more declines occur once every seven years and last about 431 days. Market gains have historically been longer and higher, but bear markets and bad news tend to get more attention in the media.

Stay the Course – Be Prepared for Volatile Markets

Today, a young investor in her 30s and a mature investor in his 70s face the same market conditions. Yet why are their investment strategies different? They have different goals and stages of their lives. Setting a course is an important part of any journey and goals drive the investment strategy, not market conditions. It’s best to stick to the game plan, unless of course, your goals have changed requiring a possible reset of your financial plan and investment strategy.

Shop the Sales

Good “savers” know the benefits of saving early and consistently. A good example is deferring 10 percent or more of your pay into your 401(k) plan. If you’re making $4,000 per month, then $400 goes into your 401(k) (plus matching employer contributions). When market levels are high, you’re buying less shares. However, in down markets, you’re acquiring more shares (they’re cheaper). Over the long term, you pay less on average per share – this is called dollar cost averaging. A similar opportunity occurs for retirees. Some retirees tighten their belts and spend less when economic conditions weaken. Prudent investors are diversified and view their wealth similar to a pension plan. They can maintain their lifestyle regardless of economic conditions.

Successful investing is part art and part science. On one hand, modern investment strategy is rules-driven or evidence-based, whereby you diversify a portfolio to achieve an expected return given the desired level of risk. But it’s also an art. Earlier we introduced how emotions and biases can impact our decision making (e.g. most people hate to lose) and that we’re not always rational.  Also “risk tolerance” is an ambiguous term, it fluctuates with our mood (e.g. great date night versus driving by an accident) and it tends to decline as we age.

Two successful strategies include patience and riding them out and the other is to lose less when they decline and participate on the upside when they advance. Build confidence in your strategies and talk with your trusted advisors.

Secure your future wisely.

This article can also be viewed at the Reno Gazette Journal.

About Brian Loy

Brian Loy writes insightful and inspiring articles about the ever-changing world of personal finance and the global trends that affect the risk and return on investments and shape the financial- and retirement-planning process.
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