The herd mentality is alive and well in the current stock market. The dramatic swings in the market in the last week took many investors by surprise. Is the bull market finally coming to an end? Will the fear over the coronavirus lead us into a recession?

I hate to disappoint you, but I don't have the answers to either of those questions.

Let's face it; it's been a darn good run for stocks since the last financial crisis hit the world. That one started in earnest in 2007, kicked into high gear in 2008, and turned around beginning in March 2009. March 9, 2009, represented the bottom of the market before the turnaround started.

Q4 2018 Gitters

Measuring the last quarter's of 2018 downturn and the negative returns for the year against 2008 should make us feel pretty good. However, for many, that's not the case.

It's not so much how much the market dropped in that quarter. It's more how it fell. We had daily moves in the Dow of 400, 500, and 600 or so points. When Jerome Powell, current chair of the Federal Reserve, softened his comments about raising interest rates in 2019, the Dow jumped by 1,100 points. Those are daily moves of from 3% to over 5%.

The media loves this. Every headline you read in December had something to do with the falling stock market. That was very unsettling to some investors.

Some people took drastic measures. I have one very nervous client who called me to talk about getting out. That reaction is a regular occurrence for him. The day after that conversation was the day the market went up by around 5%.

What should we do in the current market? Change? Stay the same? Get out? Buy more? Wait?

I'll share my thoughts on the subject and would welcome your thoughts. If you're a regular reader of Money with a Purpose, you pretty well know my answer. Even so, we'll dig a little deeper into the subject and discuss the options.

For those who love data, you're going to love this post!

Unless otherwise noted, all charts and graphs come from Dimensional Funds and Leamnson Captial.

How to Invest in the Current Stock Market

Make volatility your friend

Does that sound crazy? It isn't.

If you look at a chart of the market, be it the U.S. or foreign, you'll see that volatility is part of the package.

Take a look at the graph of the various U.S. markets below if for the evidence.

line graph of capital markets 1926-2018

The trend lines are up for all U.S. stocks and bonds. You can see it's not a straight line. The jagged sections along the way indicate volatility. It's a natural part of investing in stocks. You'll notice some significant drops represented in the chart. Some examples are the Great Depression of the late 1920s to early 1930s, the mid-1970s oil crisis, the 2000-2003 downturn (which includes 9/11), and finally, the meltdown of 2007- early 2009.

Let's look at the last one for instruction. In retrospect, we should have known, shouldn't we? Housing prices were ridiculous. Fannie Mae and Freddie Mac, the two quasi-government agencies that backed mortgages, raised their loan limits from the mid-$400k range to over $700k. No doc loans were running rampant. You remember those, don't you? Sub-prime lenders would loan just about anybody money for homes without income verification, or most any of the other standard requirements for mortgage approval.

The best and brightest economists, investment managers, and even the Federal Reserve pronounced the economy and the housing market healthy. OOPS!

Many people panicked and sold all their stock investments. Many who had their retirement planned during that time chose to delay it. What about those who stayed the course? What about those who invested more?

The bull market run

Those who stayed the course, rebalanced, or invested more cash during those crazy times have enjoyed one of the longest bull-markets in history.

The volatility we experienced in Q4 of 2018, especially in December 2018, pales in comparison to the last few months of 2008.

I've used the following chart in another article on volatility. I use it again because it's a great reminder of how bad things were during that time and offers some perspective on what we just experienced.

Image of table showing DJIA, NASDAQ< & SP 500 returns 2007*2009.

Source: Wikipedia

Now that's some serious volatility! In the 2008 markets, the drops came in big spurts over several months. For example, look at the -21.33% drop between June 27, and November 4, 2008, or the -15.9% drop between January 20, and March 9, 2020. It seemed like it might never stop falling, but it finally did. The total drop for the S & P 500 from Octobe3r 9, 2007 to March 9, 2009, was -56.8%!

For the last week of February 2020, volatility came back with a vengeance. For the week, the S & P 500 dropped by a -11.44%. That freaked out a lot of investors. Digging a little deeper into the indexes, you'll find that the S & P 500 drop wasn't the worst. The S & P 500 value index (large-cap value) dropped -12.26%, The S & P 600 value index (small-cap value) was down -12.25%.

Thought international indexes fell, the drops were less than their U.S. counterparts. The MSCI EAFE index fell –9.63%, while the MSCI emerging markets index dropped -7.28%. Looking at the last eleven years of the U.S. bull market, that makes sense. International markets have lagged their U.S. counterparts pretty significantly. We would expect that the U.S. markets would fall further with their extended outperformance. 

Lately, though, these kinds of drops have been followed by significant gains in the following days. (Update: On 3/2/20, the DOW went up over 5%, while the S & P 500 gained just under 5%).

Looking at some market history can be helpful. Perspective is valuable when making investment decisions.

How Do Markets Respond to Crisis

Another helpful way to view the current volatility is to look at how various markets reacted after a crisis that caused dramatic downturns. Of course, the lengthy bull market during the last eleven years is an excellent current example. But has that trend persisted in other crises? The chart below answers that question.
Bar chart showing how the markets recover after a crisis

As you can see, the recovery after a downturn has been meaningful through all of the above-listed crises. One thing the chart shows is the further out we go from the crisis, the better the returns are. Keep in mind that these recoveries are for a portfolio invested with 60% in stocks and 40% in bonds. A well-diversified portfolio based on your risk tolerance is the best way to help you rid out the tough times.

Past performance does not predict future results

Advisors use some version of this disclaimer when they talk about returns. Though they aren't guaranteed, past returns provide a glimpse into possibilities. Looking at the 2017 performances of the international and emerging market stocks offers just that. Below are charts comparing the 2018 and 2017 Q4 and one-year returns. Q4 is on the left. One-year returns are on the right of each table.

Image showing 2018 return s of russell 3000, eafe and emg mkts stsocks image showing 2017 returns of Russell 3000, EAFE and emg mkt stocks

 

 

 

Comparing the 2017 and 2018 returns of international and emerging markets shows quite a contrast. These markets have substantially underperformed their U.S. counterparts over the past five years before 2017. Anyone with an allocation to these markets would have underperformed their U.S. counterparts. Depending on what percentage you had in these markets, your underperformance could have been significant.

If you had additional money in small-cap and value (large and small), you would have underperformed even further. The technical term for this underperformance relative to the “market” is tracking error. It's when a particular portfolio of investments underperforms the index to which it is compared. That's the problem many people have with an evidence-based investment strategy. I've written about this in a series of articles. It doesn't feel good when you think you are underperforming.

Those who invested heavily in the U.S. markets outperformed those with international exposure. Young investors had large percentages of their investments in U.S. markets. My anecdotal evidence of this comes from numerous conversations with FIRE bloggers at FinCon last year and reading many of their blogs. They enthusiastically argued with me about their results over those invested in a more broadly diversified portfolio.

You know what? In the last ten years, they are 100% right about that. The next ten years? Time will tell. Looking at the results from the two charts in this section would indicate there are some pretty good expected returns available outside the U.S.

The last ten years, when many young investors got started, was one of the best times on record to invest.

What does the current stock market tell us

My answer – the same thing it always tells us. Stocks offer higher expected returns over long periods. Small-company stocks outperform large-company stocks over those periods. What's not shown in the charts above is that value stocks outperform growth stocks. Had they been included, you would see that outperformance too.

During all long-term time frames,  there are times when stocks underperform. Some of those times, they underperform by a lot! Does that mean you should not invest in them? Of course not. On the contrary, if you want returns over the long-term that have, historically, outperformed bonds and cash, stocks are a great way to invest. You have to take the bad along with the good, though. There will be periods that are downright nasty (see the last financial crisis).

Those who have stayed invested through these difficult times have done far better than those who got out or tried to time the markets. Disciplined investment strategy works the best, which brings me to the next point to consider.

What role does behavior play in our decisions?

The answer – sometimes, it plays a significant role. Therein lies the problem. If we follow our emotions when making investment decisions, we will likely do far worse than those who take a disciplined approach.

You've probably seen some version of the emotional decision-making chart below. It says a lot about how emotions shape the investment decisions we make.

Image of the emotional investing cycle that moves from optimism to elation to nervousness to fear and back to optimism

It's appropriate that fear is at the bottom. If fear drives us to sell when the market is dropping, that fear can be costly. Conversely, if we choose to buy at our peak emotion, that often coincides with times when the market is at or near its top (think 1999 or 2008). Keeping emotions out of our investment decision-making process can lead to greater success.

My advice is always to expect the best but prepare for the worst. It's like a form of disaster planning. If you think about how you might feel if you experienced a downturn like 2000-2003 or the last financial crisis, it can go a long way to keeping you grounded. I know of no one successful in trying to time the market. Some are successful over short periods, but no one has proven long-term success at it. Like anything, there may be an outlier or two. I prefer to take the conservative approach and let evidence guide the decisions.

Having a broadly diversified global portfolio is your best defense against the ups and downs of the market. Another factor in success comes with choosing low-cost index funds or other passive investments to execute your strategy.

Missing even a few days of up markets can cost us valuable performance.

Chart showing what happens when investors miss the best/worst days in the stock market

Use December 2018 as your guide. If you panicked and sold when the market dropped 5% in one day, you may have missed the 5% recovery the next day. You cannot win over the long term doing that. Don't chase the outliers. Follow the evidence.

Final thoughts

As the great King Solomon tells us in the book of Ecclesiastes, “there is nothing new under the sun.” These words of wisdom apply to how we invest our money as well.

Investing doesn't need to be complicated. You can be like the FIRE bloggers and invest in their beloved Vanguard three-fund portfolio. That gives you a broadly diversified global portfolio. What it doesn't do is address investment risks. Think through how you would feel if we had another financial crisis with 10% – 20% price swings rather than the 1% – 5% we had during Q4 of 2018. Trust me; it's a different emotion all together to see your $500,000 drop to $250,000 – $300,000 like many did a couple of times in the last twenty years. Stress-test your portfolio. Be sure it fits your willingness, ability, and need to take on risk to accomplish your goals.

Did I mention having a plan? Probably not. I would be remiss if I didn't remind you that having a long term investment plan tied to goals you want to achieve with your money is the best way to measure investment success. Thes goals must match your values. You need to know and understand why you're doing what you're doing. It isn't about your returns relative to the market or what your friends and neighbors say they're getting. It's about how your returns help you get to where you want to be over the long-term.

Now it's your turn. Have you stayed the course? Did the dramatic drop in the market the last week of February cause you to sell? To invest more?