As we write this blog post the afternoon of Monday, February 5, it’s been a very rough day for the US Market indexes. We believe this is the start of  the markets returning to a more normal pattern, after an historic run-up in 2017, not a sign of significant economic concerns and for most investors, it’s nothing to worry about.

We’ve written about market volatility several times in the past. To read our other takes on this phenomenon, read here and here and here.

It’s important to remember a few things we consider investing Maxims here at nVest Advisors. We stick to them for the benefit of our clients, but they’re important to remember for all investors. When markets get spooky, here are four bedrock principles you should always remember.

Maxim #1: The age we live in makes market drops faster and steeper.

First, it’s important to understand that most investing is now automated, and second, many investors buy funds that exactly mimic a particular stock market index like the Dow Jones Industrial Average (DJIA or “the Dow”) or the S&P 500. This means two things:

With trading automation, it means that sell-offs tend to be much steeper and faster than in years past. That’s because many investors have standing orders on their investments to buy or sell whenever certain changes occur. Many investors, in fact, have standing orders to liquidate their investments any time that investment falls a certain percentage in value from its highest price. So when we have a day like Friday, February 2, when the Dow fell almost 700 points, that action alone may trigger millions of other accounts to automatically sell their investments the next business day (today, February 5), which is what happened.

This creates much steeper daily drops than you would see before automated investment management. And more importantly, those steep sell-offs have absolutely nothing to do with a crisis of the markets or an economic problem. Most are just mindless, pre-programmed computer responses to other people selling on a particular day. In effect, the computer created a drop that wasn’t there for any other reason.

The other reason drops are steeper than they were in the past have to do with an investment called Index Funds.

Market indexes like the DJIA or the S&P 500 are just a collection of companies’ stocks that the index creator thinks is representative of a portion of the investing world. Instead of trying to follow 12,000 stocks simultaneously, indexes take a “representative” from each industry and watch just those representatives. In the case of the Dow, that’s only 35 companies. The S&P 500 tracks the stock prices of 500 companies. The Nasdaq tracks only select technology stocks. The Russell 2000 watches – you guessed it – 2000 company stocks as its index.

Now what does that have to do with causing sharper drops in the market?

Because indexes are just a computation of a group of other stocks’ prices, for decades, there was no way for an investor to invest in an index without buying stock in all of the companies that index tracked. Then in 1975, Vanguard created the world’s first “Index Fund”: it bought the exact amount of the exact same stocks that made up a particular index, and never changed it, unless the index changed what it was tracking.

Today, index funds are very common, and many people invest a portion or all of their accounts in them. Now, to understand why index funds have exaggerated investment returns, remember, these are funds that precisely copy the list of companies that are used to create the market indexes you see scroll across the bottom of your TV screens on CNBC or Fox Business.

When the market indexes drop, it means the stock prices of the companies in the indexes fell. That’s pretty easy to understand. But because so many people now own a fund that invests precisely in the same stocks that make up the index, when you sell your index fund in response to a drop in the index, you are selling the companies that create the index, too. That causes the index to fall faster.  – People are selling the company stocks, and people are selling the index funds that own those same company stocks.

Add automated trading, and you’ve got a turbo-charged feedback loop of  people selling those same very few companies.

That can cause the indexes (and just those companies making them up) to fall farther than the investment markets as a whole, and give you a very exaggerated short-term drop that cable news channels love to talk endlessly about.

The important thing to remember is, markets are ultimately rational when people are not. What drops irrationally will always return to normal eventually.

Maxim #2: Volatility is NORMAL.

You simply have to accept this fact if you want to be an investor. It is perfectly normal to have several 5%, 3 or 4 10% and even a 20% correction in the stock market in any calendar year. What has NOT been normal, actually, has been the long, nearly always upward momentum we’ve witnessed recently.

What you need to remember is to step back from a short-term change in the stock market and look at the bigger picture. Let us explain.

As of today, February 5, the DJIA (the “Dow”) is down over 1,800 points in two days. Taken only in the short term, that is a pretty significant decline – roughly 7% since Thursday, Feb. 1.  And visually, it does look significant – – – if you only look at the short term. Here’s a graph of the DJIA for the past 5 days:

DJIA 2-5-2018 5 Day Chart Courtesy: Google Finance

Looks like a collapse. Looks scary. And it can make you panic.

But let’s take a step back and look at that drop with the perspective of time. Here’s the Dow for the past one year, including the past couple of days of volatility:

DJIA 365-Day Chart 2-5-2018 Courtesy: Google Finance

No one can predict a day-to-day stock market, and if your focus is that narrow, it can be a terrifying ride, indeed. That’s why you need the perspective of a longer time horizon to see any meaningful change in direction. (And by the way, look at the jagged line that makes up that year’s graph. If you were just looking day-to-day, it was a VERY choppy year. Did it feel like it in retrospective? Not at all.)

At nVest, we almost never make changes to any client accounts based on a few days of market movements (one example may be the opportunity to harvest tax losses for our clients). We instead focus on making sure the money is properly invested to meet your goals and the time horizon you have to reach those goals.

Day-to-day movements are far too wild a ride to worry about. Stay focused on goals instead. (See #4, below.)

Maxim #3: You’re going to get nervous in down markets and greedy in up markets, and the Rich Guys want you to.

There’s a saying that is as old as the stock market itself:

Buy Low, Sell High

Yet that’s exactly the opposite of what most investors actually do. We tend to want to invest more money while things are UP, and get out of investments as things go DOWN.

It’s the direct result of our being emotional about our money that causes it. Here’s how this scenario plays out, over and over again, for the majority of investors, especially those who refuse to get the help of a professional advisor or planner:

 

The Cycle of Market Emotions

We’ve seen a lot of this phenomenon (the tendency to do the exact opposite of what we should do) this past year. Many very conservative clients were suddenly interested in the wildly speculative (and, we believe, Ponzi-esque) Bitcoin. Others requested, as recently as this past week, to move from Conservative and Moderate investment strategies into “Growth” and “Aggressive Growth” strategies.

Why? Because the riskier investments were “up”. 

Now why do you think the huge investors, the Rich Guys, would want you to do this incorrectly? Because when you buy stocks when prices are really high, someone is selling those shares to you at high prices. And when you are panicking and selling your investments when they’re down (and their prices are rock-bottom), who do you think is there to buy them off of you at sale prices?

Rich Guys.

If we can get you to think like a Rich Guy, you can have what they have. But you must stop making emotional mistakes with money.

The past two trading sessions are precisely why we won’t let our clients become more aggressive (that’s a nice way of saying “greedy”) late in bull markets, and it’s why we won’t make panic trading decisions after a day like today, when the Dow dropped nearly 4% in value.  It’s very normal human behavior to become overconfident and to want to take more risk after long periods of favorable conditions, but when you get excited about returns that have already happened,  it’s critical to realize that you missed it.  

Wanting to “ramp up” your investments after watching the markets roar for a while is a lot like driving your car while looking in the rear-view mirror.  You need to be focused on the road ahead, not the road behind. We don’t let our clients make that mistake.

It’s also very normal to panic and want to “jump ship” with those same riskier investments inevitably come back down. But that’s not the right solution, either. What is the right solution? Keep reading.

Maxim #4: Changes to your strategy should be goal-based, not market-based.

There is a significant difference between investors and traders, and you need to decide which one you are. Traders live and die by changes in market prices. Investors put their money into companies in which they have faith of good future prospects, hoping for a long-term profit.

Our clients are investors.

If you are an investor, that means you are putting money away for a specific future goal. It also means you are usually placing your money in a strategy that has a track record (though this is by no means a guarantee) of successfully reaching goals like yours in time frames like yours.

For example, let’s say you are investing for retirement, and that goal is 20 years away. To reach your “nest egg” goal of, say, $1,500,000, you and your financial advisor determined you need to have an investment strategy that returns an average of 8.5% per year for all of those 20 remaining years.

As an advisor, once we have this kind of strategy figured out, investing your money becomes much simpler. That’s because, not every investment or investing strategy can achieve an average of 8.5% per year. So, we create a strategy (sometimes called an “allocation” or a “model”) using investments that have historically been able to achieve that goal.

Do you see already how different this sounds that watching the talking heads and screaming headlines on CNBC, trying to keep you tuned in by obsessing about how a stock market index performed on a particular day? You’re not worried about today if you are investing for 20 years from now. It just simply doesn’t matter.

So our advice, if market movements panic you, is to make sure you have a GOAL and a STRATEGY in mind. If you just have money in the stock market without a goal in mind, you will very definitely panic at every daily change in value, because your only goal for money just sitting there, is for it not to go down.

If this is confusing for you, or if your own advisor isn’t able to help you understand the significantly important task of setting goals for your investments, give us a call.

So how should you react to sudden, surprise market movements?

The best answer, if you are capable of it emotionally, is to not react at all.  Most of us, however, do feel worried or concerned, and that emotion will cause us to make emotional mistakes with our money.

For most younger investors who are still working toward their long-term goals, down-turns in the market present nothing more than excellent buying opportunities. Think of it as the stock market is having a sale. And the exact right time to buy something is when it isn’t at it’s all-time highest price.

It’s the opposite for investors who are retired and living on their investments, or are very close to needing their investments. You can’t afford a major dip in the markets if you are selling small amounts of what you own to provide additional income. (That’s why we didn’t and never would invest you 100% in any one investment asset category.)

But even still, market downturns provide other opportunities for our retired or soon-to-be retired clients: the opportunity for tax loss harvesting, and an opportunity to add to your stock holdings when buying opportunities happen (in laymen’s terms, when things are on sale).

Market volatility is, without a doubt, the biggest psychological scare most clients experience while they are investing.  Always remember, that how we feel about something is often not the same as what actually happened. And when you take time into perspective, remember that this, too, shall pass.

If you need an advisor to talk to, or would like a second opinion on your current investment strategy, there is often no time like a period of uncertainty to review what you’re doing.