How to navigate market corrections

February 7, 2018

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The U.S. stock market has experienced some volatile trading days recently, including two consecutive sessions in early February when the Standard & Poor's 500 Index posted significant losses. Although there are explanations for these sell-offs—concerns about heightened valuations, rising inflation, and U.S. Federal Reserve policy, to name a few—they have caught most investors by surprise. And they've led to inevitable questions about whether one of the longest-running bull markets since the Great Depression is about to cool off.

Such pullbacks aren't rare. Research from Vanguard's Investment Strategy Group shows that since 1980, a significant market event—a correction or bear market, for example—has happened about every two years. So the typical global investor will have to endure many of these events over his or her lifetime. In the current environment, a market correction—defined as a 10% drop from a peak—would mean, for example, the S&P 500 would sink to around 2,585.

Downturns aren't rare events. Typical investors, in all markets, will endure many of them during their lifetime.

1 Sources: Vanguard analysis based on the MSCI World Index from January 1, 1980, through December 31, 1987, and the MSCI AC World Index thereafter. Both indexes are denominated in U.S. dollars. Our count of corrections excludes those that turn into a bear market. We count corrections that occur after a bear market has recovered from its trough even if stock prices haven't yet reached their previous peak.

It's important to put these losses into context. Market uncertainty can cause investors to diverge from their asset allocation plans as they try to insulate themselves from the turmoil. But as the graphics below show, trying to time these events can lead to costly mistakes.

Note: Unless otherwise stated, data is for the S&P 500 Index. Vanguard believes the assertions in this article would hold if international data were used.

Take the 2008 global financial crises. In a matter of months, many investors saw significant losses. However, if they held on, they would have regained all their losses and then some. It's a well-established pattern.

Dramatic losses can sting, but it's important to keep a long-term perspective

2 Notes: Intraday volatility is calculated as daily range of trading prices [(high–low)/opening price] for the S&P 500 Index.
Sources: Vanguard calculations, using data from Yahoo! Finance.

Another well-established pattern, the stock market's best and worst days have tended to happen close together. This suggests that key for investing success is to stay the course, rather than make sudden changes based on macroeconomic events.

Timing the market is futile. The best and worst trading days happen close together.

3 Source: Vanguard.

Of course, staying the course doesn't necessarily mean investors should do nothing. Periods of dramatic losses (or gains) may be a good time to make sure a portfolio's risk-and-return characteristics remain aligned with the target asset allocation. If not, consider rebalancing.

Staying the course and rebalancing can pay off, whereas altering your asset allocation can be costly.

4 Balanced portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays U.S. Aggregate Bond Index; bonds are represented by Bloomberg Barclays U.S. Aggregate Bond Index; and cash is represented by Bloomberg Barclays U.S. 3-Month Treasury Bellwether Index.

Sources: Vanguard calculations, using data from FactSet.

Consider these tips for weathering volatility.

Stay diversified: A great way to insulate your portfolio is to have exposures to stocks, bonds, and international markets in an asset allocation plan that makes sense for your risk tolerance and goals. Bonds can act as a ballast during downturns. International exposure can give you access to markets that may be generating positive performance when others are falling.

Tune out the noise: There's an old adage of never checking your account when stocks are tanking. It's smart advice. As the graphics above show, making a decision based on a recent market event usually results in a mistake.

Control what you can—costs: Expenses eat into your returns. This is a particularly painful realization when stock markets are correcting.

Revisit your asset allocation: If market corrections are making you lose sleep, it may be time to reevaluate your risk tolerance.

Set realistic expectations: Vanguard's Investment Strategy Group anticipates higher risks and lower returns over the near and medium term.

For more information, please see the infographic, How to navigate market corrections .

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.