Stock market crises are normal – don’t panic

Once again we find ourselves faced with extreme market turmoil; the Dow Jones Industrial average dropped 12 percent in the last week-and-a-half, including 513 points on Thursday alone. This is not unusual, crises happen more frequently than most of us care to remember. In other words this is normal market behavior.  You could refer to this type of market movement as a “fat tail” event meaning the market experiences far more large gains and large losses than would be expected under a normal distribution curve.

These fat tail events and the frequency of this market turbulence, is the reason behind the markets high return also known as the “equity risk premium” (the return investors demand in compensation for taking the risk).  Turbulent markets are when you earn the greatest returns (for taking risk when others are no longer will to do so); it’s just that you don’t know it at the time.  As a recent reminder, from May 2010 to July 2010, the S&P 500 Index fell almost 15 percent. By the end of the following April, it had risen more than 33 percent. In other words, the key to success is to have a plan that anticipates bear markets and then have the discipline to stay with the plan.

Your portfolio has been designed with market turbulence in mind. The following are some of the “built–in” protections we all have in our portfolios.

1) Liquidity since this crisis is financially driven, there’s the potential for markets to once again “seize up” as they did during the Lehman crisis. Hopefully this will not happen, but if it does, we have cash available and short term Government bonds available to draw upon if necessary. For those of you drawing from your portfolio for retirement income, Cash/Short term bonds are available to cover your expenses for the next five years – no worries.

2) Quality Fixed Income  When markets experience this type of turbulence,  all risky asset classes tend to move in the same direction, (the correlations will rise to one) so it is very important that we have high quality fixed income assets, enough to dampen the portfolio’s risk to an acceptable level. This is why we do not use junk bonds (high yield bonds) or low quality bonds in our portfolios.

3) Asset Allocation No one knows when, if, or even how this crisis will be resolved, therefore you should review your investment plan to determine if you’re taking more risk than you have the ability, willingness or need to take. Taking too much risk leads to not staying with the plan and experiencing permanent losses. Getting the risk right, is always the hardest part of investing and the most important.  If you have questions about this or are feeling especially nervous about staying with your current allocation, please give me a call, we’ll work it out.

There’s a tremendous amount of uncertainty in the markets as well as the world. Making sure your portfolio is appropriately tailored to address these concerns is your best safeguard. We are as well prepared as we can be for exactly this type of “fat tail” event.  I look forward to buying cheap stocks at some point, to rebalance our portfolios.

I realize that just believing in something doesn’t make it true, but I believe:

  • Capitalism will survive. Talk of the end of the US is silly.
  • Investors in general will do the wrong thing. Even those that claimed they learned a lesson in 2008 and 2009, may not be as brave as they thought they were two weeks ago.
  • Volatility is good. Sure, it hurts, but it also allows for more rebalancing by buying low and selling high to those investors following their human instincts, and not a well thought out plan.
  • There truly is opportunity in every crisis, although it may be difficult to find.

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