DON'T BE LULLED BY THE MARKET'S SMOOTH RIDE
It's Been A Long Time Since The Last Correction
By Morgan Housel, WSJ
After a five-year surge, the Dow Jones Industrial Average hit a new all-time high this past week. If you were along for the ride, congratulations.
But here's what's unnerving: It has been more than 700 trading days since the Dow closed 10% below its previous high. That is the fourth-longest run without a drop of that size, known as a correction, since 1929, according to data from S&P Capital IQ.
Some notable market skeptics have abandoned their bearish views. And bearish sentiment among investing newsletters recently hit the lowest level since 1987, according to Bespoke Investment Group, a research firm in Harrison, N.Y.
All this is making some contrarian investors nervous that the market is primed to take a tumble.
"Investors have clearly grown weary of worrying about risky scenarios that never seem to materialize," Seth Klarman, who runs the $27 billion Baupost Group hedge-fund firm in Boston, wrote to investors this summer. "The higher the level of valuations and the greater the level of complacency, the more there is to be concerned about."
Nobody knows when the market might turn. The 1990s bull market lasted more than twice as long without a correction.
But the longer we go without a stock-market pullback, the harder it will be for investors to handle when it inevitably occurs. A stable market breeds complacency. Complacency breeds bad investing behavior. Bad investing behavior breeds regret.
Now is a good time to remember that the past few years of smooth sailing aren't normal. Since 1950, the S&P 500 has suffered a decline of 20% or more sometime during the year in about one-fifth of all years, according to Chicago-based investment-consulting firm Marquette Associates. About a quarter of all years saw a retreat of 10% to 15%.
Yet, when adjusted for inflation and dividends, U.S. stocks increased more than 90-fold during this period, according to data from Yale University economist Robert Shiller.
Once you realize how normal and inevitable market volatility is, you might think of it differently when it comes. It might look less risky, and more like the cost of admission to achieving the market's long-term returns.
Here are a few things to keep in mind when thinking about how to react to the market's next inevitable correction.
How long can you stick around? Risk in the stock market is less about wondering whether a pullback will come and more about asking how long you can remain invested. An analysis of Mr. Shiller's data shows that, since 1871, a broad group of U.S. stocks has earned a positive return in 60% of all one-month periods-but in 95% of all 15-year periods and in every 20-year period, adjusted for dividends and inflation.
Having money invested in stocks that you may need for living expenses within the next five years dramatically increases the odds of falling victim to the market's inevitable volatility. Keeping a larger portion of your assets in bonds or cash might damp returns in the short run, but it's a small price to pay if it offers enough flexibility to ensure that money you have in stocks can remain invested for the longer haul, where returns are the greatest.
Investors fret about rock-bottom yields on cash these days, but the pain of having to be a desperate seller during a sharp stock-market downturn can damage your wealth in far deeper ways.
Make it boring. Your biggest enemy in investing is your own emotions. The excitement of chasing a hot market, and the fear created by crashes, tempts many investors to make buy and sell decisions at the worst possible times, rushing in at market tops and fleeing at market bottoms.
Russel Kinnel, director of manager research at Chicago-based Morningstar, says poor buy and sell decisions led the average mutual-fund investor to underperform the funds they invested in by 2.49 percentage points a year in the 10 years ended Dec. 31. For these investors, the biggest risk is the possibility that their own misbehavior will undermine the long-term returns offered by the market.
An automatic-investing plan, such as regular contributions to a 401(k), can help take the emotions out of investing decisions. Investing in consistent amounts every month promises you will buy stocks when the market is high and overvalued, but also when it's low and cheap after a market crash. Over time, averaging your purchase prices throughout the market's ups and downs may set you up for far more success than attempting to jump in and out of stocks at just the right time.
Rebalance. Staying in the market and enduring its volatility doesn't have to mean a set-it-and-forget-it approach to investing. Fran Kinniry, a principal at Vanguard Investment Strategy Group, recommends rebalancing a portfolio each year, so that a mix of stocks and bonds tracks an investor's predefined allocation targets. This is done by regularly selling assets that have performed well, using the proceeds to buy assets that have done less well.
Done with discipline over time, Mr. Kinniry says, this isn't market timing. It's a contrarian approach that uses market volatility to your advantage, buying more stocks after they become cheaper in a mechanical, rather than emotional, way.
Above all, realize that when the next market crash comes, this, too, will pass. The smartest investors may not be the most prescient, but the most patient.
"Timing the market is a fool's game," says Nicholas Murray, a New York-based consultant to financial advisers, "but time in the market is your greatest natural advantage."