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Learning from market corrections

Published: Saturday, Aug. 10, 2013 5:30 a.m. CDT

There is no way around it – markets generally move in cycles.

Although the past is no guarantee of the future, historically, the stock market has spent more time on bullish advances than on bearish retreats – which is why stocks have been considered a good investment over the years. The market also tends to retrench more than the average investor would like to think about. The traditional definition of a bear market is a 20 percent or greater decline in stock prices as measured by the Dow Jones Industrial Average or other relevant index. A full-fledged bear market can persist for many months or, in rare cases, years.

Some corrections, on the other hand, are sharp, but brief, lasting only a day or two – such as the Dow’s 500-point drop in October 1987 – or for a few weeks. Sometimes a short, dramatic decline serves as a prelude to a lengthier downturn. The 1929 crash and subsequent three-year bear market, which saw the Dow lose almost 90 percent of its value, illustrates this latter possibility.

Government and securities-industry officials are constantly learning from their experiences with previous declines. Regulations established in the wake of the 1929-1932 bear market have helped prevent another decline of similar magnitude. For example, margin requirements were raised from 10 percent to 50 percent to prevent investors from becoming excessively leveraged (indebted) the way many were in the months leading up to the 1929 crash.

More refinements were introduced after the 1987 correction, including our current system of circuit-breakers. In theory, these circuit-breakers would stretch out a decline over several days rather than allow it to gain momentum immediately. The assumption is the additional time would help curb panic selling.

Although the securities industry is committed to doing everything in its power to protect investors, it cannot prevent market corrections. It is essential for investors to take responsibility for their own investment activity and to arm themselves with as much knowledge as possible about the risks and potential rewards of investing.

In the 1930s, the Cowles Commission, formed to guide investors through the aftermath of the 1929 crash, came up with five essential rules for successful investing, which are still applicable today:

1. Invest for the long term. While the stock market can be risky over the short term, risk decreases as your investment time horizon lengthens. A good rule of thumb is that stock and bond investments should be funded with money you won’t need for at least five years.

Some investors hope to improve their returns by selling a portion of their holdings just before a correction. Such “market timing” is something that even professional investors find difficult to do well with any consistency and is not recommended for the average investor. Aside from the very real difficulty of identifying the end of one market phase and the beginning of a new one, the basic emotions of greed and fear work strongly against those who attempt market timing, constantly tempting them to overstay their positions in a bull market and to remain on the sidelines for too long in a bear market.

2. Invest systematically. One way to avoid the timing dilemma is to use a simple strategy called dollar-cost averaging – the practice of investing a fixed amount of money in a particular investment at regular intervals. Because the amount invested remains constant, the investor buys more shares when the price is low and fewer shares when the price is high. This means that the average cost per share tends to be lower than the average market value of the investment over the same period.

Dollar-cost averaging cannot eliminate the risks of investing, guarantee a profit or protect against a loss in declining markets. The success of the program depends on making regular purchases through advancing and declining market periods – and on selling when your investment is worth more than the average price you paid. Since such a plan involves continuous investment in securities, investors should consider their financial ability to continue purchases through periods of low price levels. But dollar-cost averaging does offer a disciplined method of investing in the securities markets and lowers the price you have to get to break even.

3. Diversify investments. When people think about investing their money, they probably envision themselves comparing the merits of various investments. But before they get to that step, there is a more basic decision to make: asset allocation. Asset allocation is the percentage of investment funds an investor allocates among asset classes such as stocks, fixed income, cash equivalents and tangibles/real estate.

The decision is an important one. A study of large pension funds determined that a pension manager’s allocations among asset classes had a far greater long-term effect on returns than the individual securities selected. Of course, asset allocation or investment timing cannot eliminate the risk of fluctuating prices and uncertain returns.

4. Buy quality. Periodically, investors become enamored with initial public offerings (IPOs). For those who know how to invest in them and understand the risks, IPOs can be an appropriate investment. By definition, however, IPOs involve companies whose stocks are untested in public trading. The average investor should approach this arena with extreme caution and commit no more than a small percentage of investment capital to it.

At the other end of the spectrum are the many companies with histories of consistent sales and earnings growth. Although nothing is guaranteed in the investment markets, there is a lower probability that such companies will drop off the investment map during a correction. Rather, a correction presents investors with the opportunity to acquire more shares of historically-seasoned, financially-sound companies at reasonable prices.

5. Get professional advice. Each investor brings a different outlook and level of sophistication to the markets. Most investors can benefit from some degree of professional input. Whether that means professional research on individual securities, advice on asset allocation, or entrusting money to professional portfolio managers, investment professionals are great resources for helping investors achieve their financial goals.

Particularly during corrections, it helps to have a coherent investment strategy worked out in advance and to be able to keep that strategy clearly in mind as events unfold. A qualified investment professional can help plan a sound investment strategy. 

• Patrick S. O’Connor is a managing principal, senior financial advisor, PIM portfolio manager and chartered retirement planning counselor at Wells Fargo Advisors Financial Network in Algonquin. He can be reached at 847-458-0142, emailed at p.oconnor@wfafinet.com. His website is www.algonquin.wfadv.com.

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