History shows that interest rate increases may be accompanied by stock market volatility and even sizeable pullbacks, like in 2018 when the Federal Reserve’s rate increases were followed by a brief 20% correction in the S&P 500.
The headlines around the war, sanctions and inflation all add to market uncertainty, but all of the headlines and a gradual rise in interest rates are no reason for long-term investors to abandon their financial plans.
Remember, the stock market goes up over time and along the way there are typically always reasons to sell. As a result, the stock market doesn’t go up in a straight line.
It’s also been a really good run for investors…
…and particularly over the past two years. If you just look at the below chart and the performance of the S&P 500 Index since the onset of the COVID in March 2020, is it really a shock that the stock market has been correcting recently? After all, we know volatility is normal and that the market doesn’t grow straight up to the sky.
In fact, the correction in the S&P 500 so far this year is about average in any given year from a historical perspective.
S&P intra-year declines (red) vs. calendar year returns (gray)
Despite average intra-year drops of 14.0%, annual returns were positive in 32 of 42 years:
Where we go from here is anyone’s guess, which is why it remains important to maintain perspective.
It’s easy to get confused when the headlines are bad and, at the same time, many economists and forecasters reinforce that the U.S. economy remains strong, unemployment is low, jobs are plentiful and that consumers and corporations are in good shape.
The reality is that the stock market looks forward so, while the recent economic data remains relatively strong, the market is not expecting it to stay that way. And this makes sense when you consider that the Federal Reserve is raising interest rates. The reason that the Federal Reserve is raising interest rates is to dampen demand in order to tame inflation, which will inevitably slow the economy.
How slow is yet to be determined and the topic du jour of many talking heads on daily financial programs. Will we head into a recession? Will it be a soft landing? I don’t think anyone can say at this point, but whichever it is, it will ultimately come and go like volatility in general and all recessions have in the past.
Since 1942, the average Bull Market period lasted 4.4 years with an average cumulative return of 154.9% and the average Bear Market lasted 11.3 months with an average cumulative loss of -32.1%.
Keeping this perspective is important, but it doesn’t make any of us feel any better when we see the value of what we own go down. “Losses” affect our perspective on risk and can affect our behavior as we are programmed to prefer avoiding losses more than acquiring potential gains.
When we’re fixated on avoiding our losses, we make decisions and act from a place of fear, which can result in making even bigger mistakes.
From an investment standpoint, the classic mistakes are chasing performance and selling after the market has already gone down to avoid further losses.
Many investors chased high-flying growth stocks over the past few years for “fear of missing out”, which led those stocks to become significantly overvalued and, as a result, these are the stocks falling the most in value.
Now that the market is correcting, it’s easy to succumb to fear and consider selling out of stocks. While moving to cash may feel safe, remaining in cash for an extended period of time ultimately erodes your purchasing power. If your cash is earning 0% and inflation is even a modest 2% over a five year period, then you’ll lose 10% of your purchasing power. Inflation remains a serious threat to your finances over the long-term, but it’s less obvious when you’re in cash because the face value of your assets doesn’t decline.
With this in mind, consider the -20% drop in the market in 2018 and the -34% drop in the market in 2020. If you sold your stocks in either of those downturns, then the equity portion of your portfolio would be worth considerably less today than if you just remained invested.
That’s typically the case. As we’ve mentioned frequently over the years, trying to time the highs and lows of the market is nearly impossible. It’s also not long-term investing, but rather trading. And to quote Peter Lynch, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves”.
Two of the best ways to combat our own loss aversion tendencies are to (1) have a plan and (2) take a long-term perspective.
To quote Yogi Berra, “if you don’t know where you’re going, then you might end up some place else”. In other words, if you don’t have a plan, then you probably have no idea what’s in your future. And when it comes to either saving/preparing for retirement and/or understanding if your money will last over the course of a long retirement, then the only way to know is if you have a financial plan.
A financial plan helps provide clarity on if or when you can retire and whether your money will last. It can also provide clarity on interrelated issues like how to fund short-term expenses, how much help you can provide to your family, whether or not you can leave a legacy to your heirs, how your assets will ultimately be distributed, whether you can pursue your charitable interests and how the potential costs of long-term care may impact our finances and our families.
One of the benefits of having a plan is that it helps you sort out your goals and think long-term. There is a role for cash in everyone’s lives, but like all of the components of your financial portfolio, it should serve a purpose.
Investing in stocks and bonds is a long-term play and the returns that the markets provide over the long-term are positive. But you only achieve the returns that the markets provide over the long-term by staying invested.
By keeping cash on hand for short-term needs and taking a long-term approach with stocks and bonds, you’re not focused on the daily, weekly or monthly ups and downs of the stock market, nor are you focused on the short-term impact of the red or green numbers in your portfolio. You’re more likely to meet your long-term financial goals this way.
At this point in 2022, no one can say with certainty if the market has bottomed or if it has further to go. What’s more likely is that it will work itself out over time like it always has in the past. Bull markets are normal and recessions are normal too in that they both come and go.
In the meantime, the best remedy to alleviate your fear is to revisit your plan. Regardless of how the market performs in the short-term, maintain a long-term perspective and make sure that you have a plan so you know where you’re headed.
If you don’t have a plan, well then you should. And if you have questions, then your ACM Wealth Advisor can help.