Market Correction? Remember the Ace Up Your Sleeve

After the historic growth the stock market has experienced since early 2009, many investors have felt that a healthy pullback may not be a completely negative thing. After all, we certainly don’t want another bubble, or stock prices that are clearly out of line with the earning potential of the underlying companies.

Unfortunately, market corrections never feel healthy when they occur. People get uncomfortable when the market declines, the media fans the flames by giving investors reason after reason to be afraid, and worries that this is the beginning of the next crash begin to develop.

While many investors admit that a 5% pullback is manageably unpleasant, concerns expand when the market decline hits 10% -- right when the media can officially throw around the word “correction.” As of market close on 10/17, the S&P 500 is still only off less than 6% from its high on 9/18. Consequently, we still have a ways to go before we touch the “correction” mark. Of course, we have no idea whether the drop will reach 10%, but why not mentally prepare ourselves by exploring what has traditionally happened to stock prices once that 10% decline is crossed?

The Data

Ben Carlson, an institutional investment portfolio manager, looked at the S&P data going back to 1950, and found that there have been 28 instances when stocks fell by 10% or more. Thus, on average, the market has entered an official correction every 2.25 years. The last market correction occurred in 2011, so another 10% drop at this time would correlate pretty close to the average amount of time between corrections.  Of course, the market has done pretty well since that last temporary correction in 2011. Clearly, such a drop is quite normal and far from historically concerning.

 

As you can see, the average market correction lasts just under 8 months and the median total loss was 16.5%. Of the 28 times the S&P 500 decreased by 10%, the market suffered a loss greater than 20% only 9 times (32% of the time), and a loss greater than 30% only 5 times (18%). The data confirms that although these types of large losses do occur, they really are the exception -- even after enduring a 10% loss that feels like the beginning of the end.

Your Advantage

Are you thinking “I don’t think I can stomach that median loss of 16.5%?” Then it’s time to pull out the ace up your sleeve.  Remember that the data above represents the historical performance of the S&P 500 – an index that is composed of 100% stocks. A capable financial planner would ensure you have an asset allocation mix between stocks, bonds, and cash that represents your tolerance for risk. Consequently, your portfolio likely isn’t 100% stocks. In fact, the appropriate allocation for an average investor approaching or already enjoying retirement might be closer to only 50% stocks. This means that on average, your portfolio should decline only half as much as the S&P 500 during market downturns.

This ace may bring the loss endured by our sample investor with a 50% stock portfolio down to around 8.25% during the median decline.  Are you now back in the “manageably unpleasant” range? If so, you likely have an appropriately constructed portfolio. If not, your risk tolerance may need to be reevaluated to ensure you are not exposing your nest egg to a larger loss than you can endure.

Avoid Harmful Reactions to the Market

Although the recent market pullback produces what seems like a foreign feeling, we’ve been here before. The S&P 500 declined in value by 18.64% over a 5 month period in 2011. However, an investor with a 50% stock portfolio likely only saw their account values drop around 9%-10% -- still not fun, but manageable. Of course, we don’t know whether the market is about to bounce back or continue to drop into official correction territory. If you continue to hear about the broad markets declining, remember that the average historical correction has been far from catastrophic, and that you have the ace of an appropriate asset allocation up your sleeve.