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How to Handle the Next Big Stock Market Sell-Off

Twice over the past twelve months, we have seen global stock markets decline 15% - 20%, followed by rebounds restoring markets to within 5% of their historic highs.
 
Headlines remain full of reasons to believe another sell-off is coming our way.  Maybe it will; maybe it won’t.  Either way, it is good to be prepared, because it is not a question of if there will be unsettling declines in future markets, but only when that will happen.

It is customary, and often appropriate, for financial advisors to tell their clients not to worry about such volatility.  But some people will worry no matter what their advisor says. And there are some people who should worry about such a development, but who won’t.

Here are some reasons it may be appropriate for you to allow market turbulence to serve as a call to action:

  • If you are not aware that it is very common for stocks to drop 10% or more. The S&P 500 index of the 500 largest U.S. publicly-traded stocks has declined more than one out of every four calendar years over the past century. Indeed, the market has dropped more than 10% 19 out the last 35 years since 1980, and in the majority of occasions, bounced back within a few months.
  • If you think that what happened last week, month, or year, is predictive of what will happen next week, month, or year, despite the fact that research clearly demonstrates that the market moves in ways that are impossible to predict in the short term—even the smartest computers on Wall Street have not been able to predict sell-offs reliably.
  • If you have not observed the technological, political, demographic, and economic forces that have halved the global poverty rate and created millions of middle class households in Asia, Latin America, and Africa over the past 20 years, or you think these forces are going away.
  • If you suffer psychologically when the stocks in your portfolio have dropped 10%, or when you contemplate that they could drop way more than that in the future, like they did during the Great Recession and dot.com bubble, when stocks dropped over 50%.
  • If you will or might need money you have invested in stocks to handle your cash flow needs over the next several years (e.g., down payment on a house, college for your child, or retirement living expenses), or you have not thoroughly diversified your stock holdings.
Whether or not one of the items listed above applies to you, you might find this article from the World Economic Forum of interest. Though the data was gathered in 2015, it still applies, and suggests that even if the stock market drops again, it is not likely to lead to the kind of disruption we have seen during the roughly 50% declines after the dotcom bubble and during the Great Recession.

In short, the article outlines four different kinds of asset bubbles, relying on research from the Federal Reserve Bank of San Francisco, which studied nearly 150 years of corrections and bear markets all over the world. The essay cites evidence that, when corrections are triggered by stock market growth of the sort we have seen over the past several years, such declines are not particularly threatening, and likely to rebound relatively quickly. Of greater threat are increases in stock prices that are driven by lots of borrowing (not the case now), by rapidly escalating housing values (not the case now), or the worst of all, by both heavy borrowing and skyrocketing housing values.

So for now, if none of the five items above applies to you, you might as well ignore the drama that media will whip up in response to the future declines in stock market values. Otherwise, allow the drama to trigger a mood of prudent concern that will help you think and act more effectively with your investments.
 
 
An earlier version of this blog post was posted in August 2015.

 

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