Stock Market Corrections: A Survival Guide
7 Extremely Practical Tips to Weathering Stock Market Volatility
As I write this, the S&P 500 closed down another 1.1% to end a pretty bad week. The market is now down more than 7% within the last 3 weeks. We’re not quite in official “correction” territory (which is defined as 10% or more from the recent high), but we’re definitely getting close.
Not only is the market down a bit, but we’ve got an extremely tense election coming up in the US on Tuesday and COVID-19 cases are ramping up across the world with some countries starting to shut down again. These are tense times, so I thought it might be helpful to take a step back at some data on market declines and offer 7 extremely practical tips on how to deal with your own anxiety and fear.
Embrace Volatility; It’s Normal
If you’re freaking out about a 10% or 20% decline in the market, you should seriously consider whether you should be investing in stocks at all. Even the best companies in the world experience huge (temporary) declines in price. Consider Berkshire Hathaway, which is run by Warren Buffett - one of, if not, the greatest investors of all time. If you had invested $10,000 at the end of 1964 in Berkshire stock, it would have been worth $274 million by the end of 2019.1 Yet you would have also had to endure some pretty gut-wrenching declines over that same time period. Berkshire has experienced four declines of 35% or more:
March 1973 to January 1975 the stock dropped by 59.1%.
October 1987 the stock dropped 37.1% within 25 days.
June 1998 to March 2000 it dropped 48.9%
September 2008 to March 2009 it dropped 50.7%.2
Buffett warned investors that they should expect more of the same in the future:
“In the next 53 years, our shares (and others) will experience declines resembling those in the table. No one can tell you when these will happen. The light can at any time go from green to red without pausing at yellow.”
And this isn’t a low-quality company. Berkshire Hathaway is the crown jewel of quality, yet its stock has done horribly at times. And lesser companies could see their stocks do far worse than that.
Even the broad market can experience huge fluctuations. From 1949 to 2020, stocks declined on a regular basis. Just how often?
5% or more decline occurred about 3 times per year.
10% or more decline happened once per year.
15% or more decline happened once every 3.5 years.
20% or more decline happened once every 6 years.3
So right now, ask yourself whether you could handle it to see your stock value cut in half without panicking and selling.
Seriously. Could you do it?
$1 million would be $500,000. $100,000 would be $50,000. $10,000 would be $5,000. Think about that. And if you think you would be tempted to sell, you should seriously reconsider whether (a) you have too much invested in stocks or (b) you should be investing in stocks at all. And if you do find that out, there’s no shame in it. It is far better to realize it now - when stocks are down 10% or 20% - than when they are down 50%.
Remember, Corrections Have Always Recovered
It’s impossible to say how long a corrective phase will last, but downturns have historically been pretty brief. Even bear markets (20% or more declines) have historically ended within two years.4
Once the bear market ends, a new bull market has always started in its place. Even if you had invested at the market high right before the 1929 market crash and subsequent Great Depression, you would have (eventually) gotten back to even. It took 16 years, but markets did recover. Since then, recoveries have occurred much faster. After the 1987 crash, it took about 23 months to get back to even. The 1990 bear market recovery happened in 8 months.5 And, as we’ve seen this year, the market recovered from the COVID pandemic even faster than that.
It’s easy to look at the correction and not see the end, but the end has always come (eventually).
Stop Gathering Information
Watching your portfolio decline by 10% is mentally and emotionally taxing. It makes it even harder when there are usually plenty of reasons for it to be happening (and there always are). It’s easy to look back in history and say, “Well, yeah, but what a great buying opportunity!” At the moment, it’s hard (no, impossible) to distinguish between a buying opportunity and a future bear market. You feel the pressure. What should you do? Should you buy? Should you sell? Should you do nothing?
The temptation here can be to gather as much information as you can. So you turn on the financial news. You read articles. You watch YouTube videos (thanks for watching my video, by the way). You accumulate information. Yet, how much of that information is actually helpful?
In 1970, Alvin Toffler of the International Institute for Strategic Studies coined the term “information overload,” which he describes as situations in which an excess of information results in poorer decision making.6
Modern psychology teaches us that we can only focus on so much information at a time. Beyond a certain point, we reach what psychologists call “cognitive overload.” At that point, any new information is not likely to help; in fact, more information is likely to make us less effective at making decisions and add stress.
Build Some Decision-Making Heuristics
Decision making is draining. Our brains naturally create mental shortcuts or “heuristics” to reduce the effort and help us make decisions. Gerd Gigerenzer defines a heuristic as:
“A strategy that ignores part of the information, with the goal of making decisions more quickly, frugally, and/or accurately than more complex methods” (Gigerenzer & Gaissmaier, 2011).
These heuristics can apply to all kinds of things in our life. For example, I’ve got a family history of heart disease and high cholesterol, so I try to watch what I eat. Rather than going to the store and reading every ingredient, I follow the “5-to-1 rule.”7 To determine whether an item in the store is heavily processed, you can divide the total number of carbs by the total amount of fiber. If the ratio is less than 5, it would be processed very little. For example, there are 18 carbs and 5 grams of fiber in black beans. That’s a ratio of less than 4, which is great. On the other hand, a bowl of Quaker Instant Oatmeal might have 37 carbs and 4 grams of fiber, which is approaching the heavily processed mark of 10.
Within the world of investing, there is a clear bias towards complexity. It’s a struggle for us to believe that a simple strategy could work with investing because we’re constantly fed complicated-sounding words and theories. I’m not so sure all the fancy models have done much to further our investment success. Rather than accumulate as much information as possible and create cognitive overload, you purposefully ignore all but the most important parts. The goal is to end up making a better decision with less stress than you could have using more complex methods.
Here are just a few heuristics that you could use. And, just to be clear, these are not suggestions for what you should do. They are merely examples.
Follow a cash-at-the-moving-average rule. If you find yourself tempted to move to cash every time the market drops, consider adopting a moving average strategy. Perhaps when the S&P 500 index falls below its 50 or 200-day moving average, you move 10% to cash. While I wouldn’t endorse this strategy as a way to boost your future returns (it will probably do the opposite), it may help you stay the course in a bad market. It relieves the burden of taking action, but it’s not enough cash to completely disrupt your long-term returns. If you raise 10% cash and the market goes 10% higher, you’ve missed out on 1% returns. Far better than going entirely to cash and then missing out on a 10% upside. And if the market goes down further, then you’ve got 10% in cash to be dry powder for buying back at a more advantageous time. The only problem then is, when is the right time… ;)
Invest 10% more when the market drops 10%. The opposite strategy (and probably more profitable one long-term) would be to increase your contributions when the market drops by 10%. For example, perhaps you’re saving $1,000 per month. When the market declines by 10%, you invest an extra 10% or $100 that month. If the market drops 20%, you bump up your savings another 10% or $200. By doing that, you accelerate your purchases into down markets.
Accumulate dry powder. If you can’t just bump up your savings rate by $100 on a dime, you could consider accumulating some dry powder. Perhaps rather than investing 100% in stocks every month, you could invest 90% in stocks. Over time, you’re likely to build up a bit of a cash balance. Say you do that for 10 months. Now you’ve invested $9,000 in stocks and $1,000 in cash. When the market drops 10%, your rule could be to invest 10% of your cash or $100. If the market drops again to down 20%, you could invest $200 of the cash. If 30%, then invest $300. And if 40%, then invest $400. After that, you would have spent your entire $1,000 cash buffer - but you would have done it at, on average, 30% lower than you would have before.
Rebalance to more stocks. Another easy thing you could do would be to increase your stock allocation. For example, let’s say you were targeting a 60% stock and 40% bonds. If stocks were to drop by 10% and bonds remained flat, your new allocation would be 57.4%. A simple heuristic would be to rebalance into down markets. That’s harder than it looks (and assumes your counterbalancing position didn’t also decline), but it can be one of the easier ways to deal with corrections.
There are a million other heuristics or rules-of-thumb you could create. The key is that those be simple to understand and easy for you to apply. While they may not help you increase your returns that much, they may give you just enough of a mental boost to help you know that you have a plan set in place to both weather and take advantage of whatever market volatility could be on the way.
Write Your Fears Away
I’ve been told that I’m a calm and positive person, but that’s not actually true. On the outside, I may appear that way; on the inside, I am fraught with fear and anxiety. I worry about my kids and the kind of experiences they will go through in life. I worry about making the right decisions for clients. I worry about the long-term ramifications of monetary policy on economic growth. I worry about companies taking on too much debt and reducing future dividend growth. I worry about a lot of things.
What has helped me tremendously is to write stuff down. Simple, right? It is simple, but it is amazing what happens when you take all of that stuff rattling around in your brain and get it out on paper. A lot of times, I find myself just bouncing back and forth from worry to worry with no resolution. When I put it down on paper, a few things happen. One, I see all the things that I’m actually worried about that I may not have consciously realized.
Did I take the trash out?
Is the market going to plunge into the abyss?
Did I remember to jot those notes down in our CRM system?
What if I lose my job?
Is my iPhone charged?
All those things - both silly and serious - are taking up space in my mind and I don’t even realize it. When I write them all down, the benefits I experience are enormous.
But don’t just take my word for it. Research shows that expressive writing (aka journaling) has been shown to boost your mood, enhance your sense of well-being, reduce symptoms of depression, reduce post-trauma, and improve your working memory.8
Another thing that writing does is allows you to see a history of your thoughts and, in the context of worry, see all the things that never actually materialized. 95% of all the things I’ve worried about haven’t come true; I’m able to see that plan-as-day when I read back to old journal entries. Without them, I may (wrongly) conclude that my worries always come true. Now I can say, “Look Nathan, that thing you were worried about 3 months ago didn’t come true. So it’s likely that what you’re worried about now also won’t come true.”
So if you are worried about the markets, your portfolio, your future, the election, the weather, your kids, your parents, yourself, whatever… write it down. Take a sheet of paper and a pen and just write. Just write until you have nothing else to write about. If you think of something that’s undone and needs to be done, note that so you can come back to it later. I denote mine with /TODO. Capture all the outstanding to-do items in your to-do list system. When you’re done, just write the date on the top right corner. In a month, re-read your worry page. You’ll probably find that 95% of what you were worried about didn’t come true.
After you do this, you’ll find a few things: (1) you will see just how many things were taking up real estate in your brain (2) you will feel much more mental clarity, and (3) you will be able to see your worries from a third-party perspective. Once they are captured on the page (and not rattling around in your head), you can think clearly enough to decide whether or not you can do anything about them. And if you can, then you’ll have the mental clarity to think about what to do about them.
Get Some Help
If you’re finding it difficult to make good decisions with your portfolio, consider seeking out some help. It doesn’t need to be a professional advisor (although it could be). It could be a trusted friend that has some investment experience. It could be a family member (not your spouse) that you know has experienced ups-and-downs in the market. Tell them what you’re feeling about the portfolio. Tell them that you’re worried about [insert whatever you’re worried about here] and that you’re considering doing [whatever you’re considering doing].
Just having that conversation could be the difference between you doing something irrational with your portfolio and sticking it out for the long-term. And that alone can be the difference between locking in 30% losses and going on to experience the full benefits the next bull market will bring.
Change Your Mindset: Love Volatility; Don’t Fear It
Part of the reason you fear investing in stocks is because of volatility. You view it as a bad thing; you should view it as a good thing. In fact, if it weren’t for volatility, stocks wouldn’t really be that attractive of investments.
If the stock market were to go up by the same amount each year, wouldn’t it be considered risk-free? And if the stock market were risk-free, why should it make more than the risk-free rate? It wouldn’t. The additional return you get from investing in stocks is only available because the market is volatile and uncertain. Without that uncertainty, you wouldn’t earn higher returns.
Rather than thinking of market volatility as something to fear, think of it as something to embrace. Something to actually like and look forward to. When the market is volatile, it’s an opportunity for you to demonstrate your own emotional fortitude and push forward when others around you are dropping out. It’s a chance to buy stocks when everyone else is selling. It’s a chance to master your own emotions and press forward, even in the face of difficult times.
Take Heart, My Friend
Investing is hard. It’s not the technical details that are hard. I’m convinced that everyone has the IQ to do it. The problem generally is not intelligence, talent, or foresight. The problem is your emotions. Investing is not about mastering numbers or spreadsheets; it’s about mastering yourself. I hope these tips help you make better decisions and I hope this is encouraging for you. Take heart, my friend. We’re going to get through this!
If there is anything I can do to help you along the way, I’d love to hear from you. Simply reply to this email or click this link.
Happy Halloween, everyone.
Alpert, Gabe. “If You Had Invested in Berkshire Hathaway When Buffett Took Over.” Investopedia, https://www.investopedia.com/articles/markets/020916/if-you-had-invested-right-after-berkshire-hathaways-ipo-brka.asp. Accessed 30 Oct. 2020. ↩
Caplinger, Dan. “Buffett to Berkshire Shareholders: Be Prepared to Lose Half Your Money.” The Motley Fool, 18 Mar. 2018, https://www.fool.com/retirement/2018/03/18/buffett-to-berkshire-shareholders-be-prepared-to-l.aspx. ↩
Sources: Capital Group, RIMES, Standard & Poor’s. Frequency and length as of 12/31/19. Average frequency assumes a 50% recovery of lost value. Average length measures market high to market low. ↩
Average 401 days. Sources: Capital Group, RIMES, Standard & Poor’s. Frequency and length as of 12/31/19. Average frequency assumes a 50% recovery of lost value. Average length measures market high to market low. ↩
American Funds. https://www.capitalgroup.com/advisor/public/authentication-0.htm?next=/advisor/tools/guide-to-market-volatility/articles/what-past-market-declines-teach-us.html. Accessed 30 Oct. 2020. ↩
“Too Much Information: Ineffective Intelligence Collection.” Harvard International Review, 18 Aug. 2019, https://hir.harvard.edu/too-much-information/. ↩
“Follow the 5-to-1 Rule for Packaged Foods.” NutritionFacts.Org, https://nutritionfacts.org/2018/05/08/follow-the-5-to-1-rule-for-packaged-foods/. Accessed 30 Oct. 2020. ↩
“83 Benefits of Journaling for Depression, Anxiety, and Stress.” PositivePsychology.Com, 14 May 2018, https://positivepsychology.com/benefits-of-journaling/. ↩
Nathan. Timely and very useful article. I also like Dr Greger of nutritionfacts.org, to the point of becoming 90% WFPB, allowing me two meals per week of "dirty" stuff. Investing wise, one should put away some money for rainy days to reduce the pressure of closing positions at the worst possible time. I fully embrace the idea of Volatility as a friend. To that end, it's good to learn about options and the asymmetric protection they provide if done properly. Tail Hedging (TH) is a good idea, but only to protect from catastrophic (>25%) drops, otherwise it becomes too expensive. I'm currently complementing TH with some collars in key positions with low/zero dividend, like BRK, that I'm ok to turn in if the Call levels are hit. Keep up the good work!