The Great Correction of February 2018

February 12, 2018  | By Kevin Smith

Last week was a doozy! The US stock market had been on a record-breaking streak of sessions without significant declines, so sharp drops in the market last week come as a stern reminder that we have been investing in unusual times. I like to think of it as a test. How does your commitment to your investment strategy hold up under pressure? This is a great opportunity to reflect.

To put last week in perspective, the chart below shows the frequency of daily returns on large U.S. company stocks since 1989. The higher the bar, the more often the daily return fell in that range. I marked where the returns for Monday and Thursday of last week would fit. Those were the kind of days that happen less than 2.5% of the time, so they were definitely wild and unusual days in the market, but they do happen.

If we zoom out a bit and look at the largest market swings during each calendar year, both up and down, 2017 stands out as a VERY unusual year. [Black bars indicate largest upward movement during the year, and red bars indicate largest downward movement during the year. The blue bar is the actual return during that year.] In contrast to 2017, take a look at 2009! Both years ended with 20%+ returns, but took very different paths. Through this lens, the steep declines of early 2018 do not appear so unusual.

With a historical understanding of market volatility fresh in mind, the next question is: What should we do? Here are some choices:

1) Do nothing. This approach is entirely rational. It has been said that 95%+ of successful investing involves doing nothing. Another word for this is ‘discipline’. Staying invested through good times and bad has served disciplined investors quite well throughout many market cycles. The odds are in your favor.

2) Buy stocks with cash. If you have excess cash sitting on the sidelines, you may consider this a ‘buying opportunity’. It is not yet a significant opportunity by historical standards, but waiting around for a better opportunity does not usually pay off. If investing that cash all at once is uncomfortable, the strategy of layering funds into the market over a period of weeks or months is a reasonable compromise.

3) Rebalance. Let’s say your targeted risk exposure is 75% stocks and 25% bonds. If this past week has left you with 70% stocks and 30% bonds, you have an opportunity to ‘rebalance’. This means, for example, selling 5% of your bonds and using the proceeds to buy stocks at the current lower prices, restoring you to the target portfolio. [If you have hired us as a discretionary manager for your accounts at TD Ameritrade, we are actively making these changes for you.]

4)  Change your risk exposure. If you are realizing that you have more at risk than you can stand, now is a good time to carefully reconsider your commitment to an allocation between cash, bonds and stocks. Making thoughtful decisions about this is some of the most important work we can do as investors.