Three Things to Remember When Markets Decline

By Jack Forehand (@practicalquant) — 

“People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.” 

— Peter LynchOne Up On Wall Street

Market volatility is back. And with it comes a significantly elevated potential for rising emotions and the poor decision making that comes with them. For investors, now is as good a time as ever to take a step back and remember what works over the long-term in investing, why it works, and what it takes to get there.

So in that light, I wanted to take a look at three principles that all of us should keep in mind during periods of volatility and market decline, like what we are experiencing now.

1) Stocks Are the Best Long-Term Investment There Is

There is no asset class that outperforms stocks over the long run. They outperform bonds. They outperform commodities. They outperform cash. And for all the Bitcoin supporters out there, there is no currency nor other store of value that beats stocks. Stocks have trounced gold over the long run. There is nothing you can invest in that has more evidence to support its long-term performance than stocks.

Take a look at the chart below of the long-term performance of stocks and try to find the recent decline. You may see the slight blip all the way to the right that represents it, but it is inconsequential relative to the rest of the chart. The same thing will be true whether we get a 10%, 15% or 20% decline here. Even 2008 looks minor relative to the long-term returns.

But with performance comes risk. The path to long-term outperformance in stocks includes sitting through substantial pain. That pain is the price you pay for the long-term results you get. The table below shows the declines during the worst bear markets U.S. stocks have experienced. Despite these declines, stocks have always come back to reward long term investors. If you can’t endure the pain, you will not get the long term results that stocks offer.

There is a reason why most investors underperform the funds they invest in, and how they act during periods of volatility and decline is that reason. When you are faced with volatility, keep in mind why you invested in stocks in the first place – because they are the best long-term investment there is. But to get to the long-term, you have to endure the short-term and the pain it can sometimes bring

2) Volatility is the Rule not the Exception

We just finished a year that was unprecedented. There had never been a year before where the S&P 500 was up every month. Take a look at the chart below – historically, the data shows that there is about a 40% chance of any month being negative, so last year’s record setting trend of 12 consecutive months of positive returns has a probability of about 0.2%.

We all tend to anchor to the recent past and extrapolate it into the future. Our definition of normal can change rapidly. We think what has recently happened will happen forever. The market has historically had 2% down days about once a month. Last year it didn’t have any. So when we get a 2% decline now, it feels unprecedented, but it isn’t. It is just the market working the way it always has.

The most important part of volatility for investors is not the volatility itself. It is how you react to it. If you don’t react, it becomes a blip on the radar of the long-term chart above. If you do, it results in a much lower probability of reaching your long-term goals.

3) Conviction in Your Investment Approach is Essential

The most important thing about investing is often not what you invest in, but how much you believe in it. The reason is that conviction is what allows you to stick with your plan when times get bad. If you begin to question your investment approach during periods of market decline and volatility, then you won’t stick with it. If you don’t stick with it, you won’t achieve your goals.

If you setup an investment plan that makes sense given your goals and risk tolerance, and you believe in it, then you will resist the temptation to question it when things are bad. In fact, you will likely use those periods as opportunities to add to your investment positions because you will see the cheaper prices as a buying opportunity.

And a lot of this has to do with how you are wired as a person. For example, I am a big believer in value stocks. That conviction leads me to stick with them during periods where they underperform, as they have for a long time now. I look at those periods as opportunities to enhance my long-term returns by adding to them rather than times to panic. But that is just me.

Your version of value stocks may be growth stocks, or index funds, or a 50-50 stock and bond portfolio. It doesn’t matter. What matters is that you only invest money in risk assets that is truly long-term money and that your conviction in those risk assets is unwavering. If you have that level of conviction, declines like we are seeing now, regardless of how bad they get, will be an opportunity rather than a time to panic.

It may very well get a lot uglier before all of this is over. You will likely get tested more than you have so far. But regardless of the magnitude of that test, the consistency of the response is what matters. If that response is to have patience and stay the course, all of this will eventually just be a blip on the radar.




Photo: Copyright: olivier26 / 123RF Stock Photo


Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.