Written By: Brian McKinney, CFP®
As investors, it's natural to feel uneasy when the market experiences a decline. After all, studies have shown that the brain processes both mortal danger and financial loss in the same area. But it goes without saying that it’s vital that we keep our emotions, and our investment decisions separate during volatile periods in the market.
In order to do this best during market declines, you will need manage your expectations appropriately, maintain a long-term perspective respective of your time horizon, and remain invested in times of volatility.
Framing Long-Term Perspective
Since 1926, the S&P 500 has experienced an average of one bear market every seven years. For way of background, a bear market is defined as a decline of 20% or more from a recent stock market high. Assessing this same time frame, if you were to invest $100 into an S&P 500 index fund at the start of 1926 and reinvested all dividends, you could have expected to earn an estimated annualized return of 10.04% per year (as of 12/31/2022).
What this shows us is that financial markets will go through periods of decline and appreciation, but over time performance is positive. With this perspective, to keep our focus on this longer-term mindset, it is important to maintain discipline and focus on what is in our control.
Enduring Volatile Markets
From the start of 2010 to the end of 2021, we saw a historic bull market. The S&P 500 had a cumulative return of 411.63%, or 14.57% per year. Following this, the past 12 months that made up 2022 have been our reminder that, to achieve superior growth and capital appreciation of this magnitude, financial markets can (and will) experience periods of decline.
Using history to gauge the outlook of the future, we can look back to 2008 and 2009, where the market experienced a significant decline during the financial crisis. But, as we all know, it eventually recovered and reached new highs. Past performance is no guarantee of future results, though, it is important to remind yourself that your “time in the market” is more important than “timing the market.”
So, what can you do during a market decline to position your portfolio for the long term? Here are seven strategies to consider:
- Diversification: adding a variety of different assets classes to your portfolio can reduce the possibility of unsystematic risk and concentration risk.*
- Rebalancing: A market decline can create an opportunity to rebalance your portfolio by buying assets that have become relatively cheaper and selling those that have become relatively more expensive (i.e., the adage of “buy low, sell high”).
- Tax loss harvesting: If you have investments in your portfolio that have experienced a loss in a taxable account, you could consider selling them and use those realized losses to offset future capital gains. This strategy can help reduce your overall income tax liability.
- Roth conversions: If you have traditional retirement accounts, such as a 401k or traditional IRA, you may want to consider converting some of those funds to a Roth IRA. With a Roth, future gains will be tax-free, which can be beneficial if you expect your tax rate to be higher in the future.
- Increase investment contributions: If you have cash on hand or have been considering contributing more into your 401k plan at work, a market decline can be a good time to increase your investments. By “buying into the dip”, you can potentially benefit from a market recovery.
- Consider pausing investment distributions/withdrawals: If you're already in retirement and have sufficient levels of cash in the bank to live your lifestyle, you may want to consider pausing your investment distributions for a few months and use your liquidity to fund living expenses. This can allow your investments to potentially recover any losses and give you more assets to work with when the market rebounds.
- Don't look at your long-term investments on a daily or weekly basis: Per the theme of this article, it is important to keep a long-term investment mindset, especially during times of market volatility. Instead of getting caught up in the day-to-day fluctuations of the market, try to focus on your long-term goals and the things you can control.
Predicting the Market vs. Preparing Your Portfolio for Volatility
It's also worth reiterating that trying to forecast market returns is an ineffective errand. Instead of trying to predict what the market will do, it's important to focus on things you ‘can’ control, such as diversifying your portfolio, maintaining a long-term perspective, and staying disciplined.
Remember, you ‘cannot’ control how the stock and bond markets move, how interest rates change, or what changes congress might or might not make to tax legislation. But you ‘can’ control how much you spend, how much you save, how much risk you take in your portfolio, and most importantly, how you react when the markets go through what we can call “tough times.”
Some of these strategies and thoughts may be considered as “the basics” or simply what you have learned over the years from colleagues, friends, and mentors. But given the recent uncertainty in financial markets (following an extremely successful bull market that lasted over a decade) and in the economy (global and the U.S.), we must ensure we remain fundamental in our approach, to eliminate the ‘avoidable’ mistakes.
While market declines can be unsettling, they are a normal part of the investing cycle.
*Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.