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The Lessons In A Correction Thumbnail

The Lessons In A Correction

At the end of each year, I write a blog and give a speech on the lessons the markets provided on prudent investment strategy. In most years, markets provide remedial courses, covering lessons taught in previous years—which is why one of my favorite statements is that there’s nothing new in investing, only the investment history you don’t know.

The market “correction” (defined as a drop of at least 10 percent from the previous high) of August provided investors with an opportunity to learn some lessons. In my discussions with investors and advisors alike, I found the usual wide spectrum of lessons learned.

Look through the list and see which, if any, of the lessons listed below describes what you learned during the correction. Hopefully, it is the first one listed below:

  1. Did you learn that you were well prepared, thanks to your written investment plan, which anticipated that, over time, you were virtually certain to experience many such drops? Thus, you not only were able to avoid panicked selling, but you could enjoy life, not losing sleep worrying about the market’s precipitous fall. As a further test: Did you learn that you were able to perform any required rebalancing (buying the equities most beaten down) as prescribed in your investment policy statement?
  2. Did you perform tax-loss harvesting, taking advantage of any significant losses while purchasing similar equities (which could be swapped back after 30 days to avoid the wash-sale rule) and possibly even undergoing a Roth conversion (taking advantage of the lower valuations)?
  3. Did you learn that you were taking more risk than you could stomach and were tempted to sell? Even if you avoided panic-selling, did you find that you were worrying a great deal about your portfolio and thus couldn’t sleep well? If so, you should admit that you were overconfident in your ability to take risk and should lower your equity allocation. If you do, you might consider also “tilting” more toward small and value stocks if you need the higher expected returns those stocks provide to meet your goal—offsetting the lower expected returns from the lower equity allocation. Historically, doing both at the same time has cut downside risk.
  4. With emerging market stocks falling much further than developed-market stocks, did you learn you were more subject to tracking error risk than you thought? And with the news centered on the problems in China’s economy, were you tempted to reduce your international holdings? If either is true, you should consider changing allocations. While I believe the right starting point for choosing an international allocation is the market’s weighting (about 50 percent), it’s far more important to choose an allocation you can adhere to, in both good and bad times. Unfortunately, many investors are subject to a home-country bias. If that’s true in your case, you will be more subject to abandoning your plan when international stocks underperform—which they are likely to do about half the time!
  5. Did you learn that after almost seven years of good returns, you had become complacent about the risks of equity investing? Perhaps trying to make up for the low yields on safe fixed-income investments due to the Federal Reserve’s zero-interest-rate policy, you began taking on more risk by investing in higher-yielding securities such as junk bonds, emerging market bonds, preferred stocks and even dividend-paying stocks as substitutes for safe bonds? If so, it’s a good time to correct that mistake. None of these investments are substitutes for safe bonds. As we saw during the correction, these securities tend to perform like stocks at just the wrong time: when risk appears and the bear emerges from its hibernation.
  6. Were you able to “tune out” the noise of the market, turn off CNBC and avoid listening to, or taking the advice of, gurus who were predicting bad things? If not, it’s also likely you are taking more risk than you should be, and it’s time to adjust your investment plan, or perhaps write one if you don’t have one (it’s pretty hard to adhere to a plan you don’t have). As Warren Buffett stated in his 1991 annual letter to Berkshire shareholders: “We continue to make more money when snoring than when active.” It’s important to understand that the financial media is usually not helpful in terms of providing prudent advice. In fact, in times like last week, the media can be downright harmful as they try to get everyone to “pay attention.” You want CNBC to be your source of financial advice no more than you want late-night infomercials to be your source of medical advice.
  7. Did you find yourself checking the market and your values more often than during the last seven-year bull market? That can be dangerous; research shows that the more often we check the market and our values, the more likely we are to act—when inaction is the more prudent strategy (with the exception of rebalancing and tax-loss harvesting). Frequent checking creates problems in bear markets because the pain of losses is felt so greatly that our stomachs take over decision-making from our heads. And I’ve yet to meet a stomach that makes good decisions.

I’ve also found that investors can learn the wrong lessons from such corrections. The wrong lesson in this case is that markets always bounce back from corrections, and thus you should be a buyer when they occur. We could just as easily have seen the 10 percent correction turn into a 20 percent bear market (or a lot worse, as was the case in 2008). Just consider Japanese investors, who have been waiting for over 25 years for their market to return to the level it was at in 1990. In fact, the Nikkei is still trading at less than half its peak level.

Hopefully, you learned the important lessons that having a well-thought-out plan—one that fully anticipates both that bear markets are like death and taxes (inevitable), and that being prepared to deal with them—gives you the best chance of achieving your financial goals. Planning, patience and discipline are the hallmarks of all good investors.

Larry Swedroe is the director of research for The BAM Alliance.   

This commentary originally appeared September 2 2015 on ETF.com.

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