During my time as a financial advisor, one of the hardest things to get people to understand, to really understand, is that stocks go down as well as up. Exactly when that will happen is almost impossible to predict, but when it does, fear often takes over and losses happen much quicker than gains.
When you point that out to them they acknowledge the possibility, but when faced with the likes of what we are seeing now they are still shocked, and somehow convince themselves that you, as their advisor, didn’t do enough to warn or protect them.
The simple fact is that stock investing, indeed investing of any kind, carries risk. Ultimately, though, one of the biggest influences on your long-term success or failure is how you respond when that risk makes itself evident and stocks fall.
Making an effort to put things in context can give comfort, and also help you to avoid making decisions that will turn a bad situation into a disaster.
The chart above, which shows the S&P 500 futures contract (ES) over the last year, is pretty scary, but if you look at a twenty-year chart for the same thing, it looks a little different.
It is still a big drop, but after such a massive run up, hardly surprising when put in context.
Context also matters when assessing the impact of the decline. For many people the extent of the point drop makes the last few days much scarier than it is. Old people like me can easily remember when a three or four-hundred-point decline in the Dow was big news, so a loss of over a thousand points in a day looks and feels like a calamity.
However, that is a drop of around 4.6%, and over the last twenty years the market has fallen by more than that on twelve occasions. So, as shocking as it may be, this is not a rare event. It is also worth keeping in mind that we started this drop from a record high, so obviously there was no long-term effect from any of those bigger one-day drops.
Even when we look at the chances of this being another 2008-like moment, context can give you comfort, this time by viewing the losses in terms of the overall, fundamental state of the economy. At that time, there was a real fear that the banking system was about to collapse. Banks were taking massive losses on risky mortgage securities and began to doubt the ability of counterparties in the same situation to meet their obligations.
That problem had been brewing for some time before it came to a head. There is, if we trust the evidence, no such problem now. Bank balance sheets are much stronger today, in part due to their natural reaction to the crisis and in part due to mandated protections.
The overall economic picture and outlook are also good. Consumer and business confidence are high, wages are climbing, unemployment is falling, and earnings are at record levels. This has been a sustained recovery from the recession and has naturally accelerated near the end.
What we are seeing here is selling based on a fear that the recovery is too strong, that growth of over 3% will be a problem.
Again, to those of us whose memory goes back before 2008 that is laughable.
Part of the problem is that the memories of many of the people making the decision to sell at this point do not go back that far. Wall Street is, and has been for years, dominated by young people, and for anyone viewing the recent action who has only seen the last ten years or so of steady increases in stock prices, this looks like Armageddon.
Somewhere within those organizations, however, will be some more experienced traders who will point out that this is not unusual, and that on every occasion in the past, such moments have, with hindsight, been buying opportunities.
I don’t want to sound too Pollyannaish here; there is a strong case to be made that tax cuts and additional spending (just as we hit full employment and wages and prices start to jump) is irresponsible, or even cynical from an administration under pressure. But, when looked at in context, things are really not that bad, and the hard evidence suggests that before long we will all be scratching our heads and asking “What was all that about?”
We have a robust economy that is about to be given another boost from a big corporate tax cut and a stable financial system, and, while the losses may look alarming, they are of a magnitude that we see about every two years. Context matters, and in context, selling now looks like a big mistake.