February 19, 2018
A few weeks ago, I went for an early morning run before the sun came up. I barely made it off my street when suddenly, my foot clipped a break in the sidewalk and I went down.
Unfortunately, the darkness had concealed the elevated sidewalk. On the flipside, the lack of light also shielded my shameful concrete dive from any potential onlookers.
As I picked myself (and my dignity) up from the ground, I realized that my fall took a bite out my hand, both elbows, and a shoulder, and bruised my hip.
It had been years since I experienced a fall while running — so long, in fact, that I forgot about the risk of falling. Even worse, I forgot how much it hurt to strike the concrete.
And if you’re an investor in the market right now, you can probably relate.
We’ve watched the market steadily — and sometimes dramatically — trend upward since the beginning of 2016. It’s been a long time since investors experienced a stumble and fall, but that’s exactly what happened earlier this month.
If you’re like many other investors, you might have forgotten the feelings of pain and nervousness that naturally come with a market selloff and seeing declining portfolio values. It’s been a while since we last felt this way.
Historically low volatility in 2017 altered the perception many investors had of normal market fluctuation. A look back helps illustrate just how much the lack of market volatility in 2017 distorted investor’s reality of what is normal.
Since 1980, the S&P 500 index has finished up or down more than 1% on a given day an average of 63 days a year – roughly 25% of the trading days in a year. In 2017, by comparison, the S&P 500 index finished up or down more than 1% just 8 times all year, or 3% of the year.1
The extreme lack of volatility last year could put you at risk of forgetting what normal market volatility feels like. And that, in turn, could leave you vulnerable to the mistakes investors make when they panic and react emotionally.
Market volatility was not only historically low in 2017, but markets also seemingly marched in a single direction (up!) throughout the year. If we look back at historical market activity, we can see that it’s reasonable to expect about three 5% pullbacks and one 10% correction per year.
In 2017, not only did the S&P 500 not see a correction, but investors didn’t see a single 5% pullback, either. The largest decline in the S&P 500 all year was less than 3%.
It’s hard to remember this after a year like 2017, but we need to understand that market corrections are normal, and even healthy for stocks. They can also serve as a valuable reminder of the inherent risks of the market.
In the absence of periodic downturns, investors run the risk of overreacting when market volatility does return.
For a driver who takes the highway daily, driving 60 MPH doesn’t feel very fast. But if that driver only takes back roads for a year, getting back on the highway after 12 slow driving months can make 60 MPH feel more like 100.
When markets experience long periods of stability, market volatility can feel gut-wrenching to investors. And gut-wrenching feelings often precede poor investment behavior.
After the fall I took while on my early-morning run, my instinctive feelings were to slow down to avoid another fall. My instincts were wrong.
The lesson should have been not to slow down, but rather to be more aware of the risks while running.
As an investor, you might not remember how it feels when stocks fall after enjoying periods of calm for so long. This can put you at risk of overreacting when the next market decline happens.
Big overreactions — like selling to go to cash or making one’s portfolio too conservative — can cause serious harm to your long-term financial goals.
To mitigate these risks, we advise investors to guard against complacency and overconfidence when markets are steadily climbing as such behaviors can lead to overly-aggressive portfolios. And to avoid overreacting when markets drop, investors should focus on owning the right mix of stocks and bonds based on their risk tolerance and the time horizon of their financial goals.
Of course, we might also advise to avoid running in the dark.
Source: 1 Morningstar Direct