Global stocks fell sharply this week following confirmation that the coronavirus (COVID-19) has spread beyond China to Europe and South Korea, raising questions about the potential impact on global economic growth and business supply chains dependent on China. Investors are fearful that the spreading virus could sap both business and consumer demand and tip the economy over into a recession.
While a 1,000 point move in the Dow Jones Industrial Average sounds scary on the surface, it is within the normal realm of market moves historically especially when viewed in percentage terms. Using history as a guide, the stock market on average has experienced a 5% dip every three months and a 10% drop every nine months1. We just experienced a 10% move down from the market’s all-time high in early February, and sit 6% below where we started at the beginning of the year.
Are stock market corrections inherently bad? Market corrections, defined as a drop of 10% or more, are part of a normally functioning stock market and help reign-in speculation and prick overheated asset prices. Otherwise the market and investors alike may succumb to the “Greater Fool Theory.” That is that the price of stocks or any other asset gets severed from reality and purchase decisions are made not on intrinsic value (such as the level of profits or dividends), but rather on irrational beliefs that market participants will drive prices higher and higher. Telsa's stock price movement this year serves as a nice example of the Greater Fool Theory, as does the tech stock bubble of the late 1990s.
How to manage risk, and thus volatility. Unfortunately, there is risk in investing, there’s no getting around it. However, two of the most effective strategies to control risk are portfolio rebalancing and broad diversification. Broad diversification is the “only free lunch” within investing. By holding a diversified selection of different asset classes investors have enjoyed smoother rides during both bull and bear markets2. This is because asset class returns are not perfectly correlated. For example, stocks and bonds zig and zag at different rates, as do U.S. stocks and international stocks, and large company stocks and small company stocks. Having a balance of each asset class can lower volatility and potentially increase returns over time.
In addition, regular portfolio rebalancing can help reduce risk and aid performance3. Rebalancing ensures your asset allocation is on tract and hasn’t strayed too far away from the desired levels. For example, with the past year’s strong global stock market performance, it may have lifted the stock allocation to a level that is higher and perhaps more risky than preferred. In cases such as these, we are actively rebalancing by reducing the proportion of stocks in the portfolio and increasing bonds and other non-stock assets. We’ve been working tirelessly in this regard to realign our clients’ portfolios back to their ideal allocation. If you have questions on yours, please let us know.
Conclusion. For most investors with a long-term investment plan, these kinds of market pullbacks should be viewed as bumps in the road. If you're investing for the long term, the best response is to take no action. Of course, if you are uncomfortable with the level of risk in your portfolio, please reach out and we can review your situation.
1 Ned Davis Research, Davis Advisors Research
2 JP Morgan Guide to the Markets. Asset Class Returns
3 JP Morgan Guide to the Markets. Rebalancing and Risk Management.
This content is developed from sources believed to be providing accurate information, and provided by Criterion Capital Advisors, LLC. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.