Over the last few weeks, investors have experienced declines in their stock market portfolios, which is something that is part and parcel with this kind of investment activity. The ups and downs of these investment markets is something that is considered “normal” and is accepted as an investment truth, even though the phenomenon is rarely analyzed by the typical investor.
For those of you who have attended my Private Practice Millionaire® Academy, you will remember the concept of “Perception Management.” If you need a reminder, it is easily demonstrated that your perceptions of what is happening economically and financially in our society is being carefully controlled so that you make erroneous decisions based on what you THINK is true, not what is actually true. The proof is summed up in the precarious financial condition of the average American household.
A great example of financial propaganda is the idea of a “market correction.”
To begin with, the value of any asset, at any time, in any market is what the buyers and sellers agree upon at that moment in time. In other words, it is the equilibrium of the supply and demand of those assets. If the market prices go up, then there is more demand than supply. If market prices go down, then the supply outweighs the demand.
A market correction, then, is a situation where there are more shares of stock available than the number of buyers of those stocks. This is somehow promoted as a negative thing.
According to Investopedia, a “correction” is “a reverse movement, usually negative, of at least 10% in a stock, bond, commodity or index to adjust for an overvaluation [emphasis added]. Corrections are generally temporary price declines interrupting an uptrend in the market or an asset. A correction has a shorter duration than a bear market or a recession, but it can be a precursor to either.”
The Merriam-Webster dictionary defines “correction” as “the act of making something (such as an error or bad condition) accurate or better; the act of correcting something.”
So, a market correction is a decline in prices to get back to what the assets are really worth. By deduction, then, it is our expectation as investors that the assets become overvalued again so we can make a return (provided, of course, that we purchased those stocks at or near the bottom of the correction).
Speculating this way is incredibly risky, because you are dependent upon the hope that there will always be more buyers than sellers, more demand pushing prices above their true and accurate levels so you can make a profit. It’s really a bummer if you continue to buy after prices trend up again because you KNOW you are overpaying! Daunting, isn’t it?
If you choose to invest in speculative markets, know that you are going to take some hits in down markets.
So, how should we treat these market corrections?
First of all, every investor should have a Household Investment Policy. This is a written, formal description of an investment philosophy that outlines the terms and general rules to be followed when investing assets. It includes risk tolerance, asset allocation and which investment vehicles will be permitted (and prohibited) to achieve known objectives.
This is what all professional investment managers do—all mutual funds, pensions, endowments, etc. They are held accountable for their investment decisions based on their adherence to the agreed-upon policy. No investor of household assets should invest any money prior to formulating and adopting this formal document—that is, if you want professional-quality results. Then, when markets do what they do, there is a certain course of action to take that has already been considered optimal.
Work out an investment plan, know your risk tolerance and keep your discipline, especially through market turmoil.
Secondly, adjust your expectations. Many investment managers will boast track records of double digit returns as a reason for you to turn over your investments to them. This is a rookie mistake for 2 reasons: 1) past performance is NOT an indicator of future results, and 2) you have no idea the level of risk you are actually taking to produce those high returns.
Too many investors look at track record as the main criterion in choosing investment funds. Somehow, we try to predict the future by what happened in the past. This doesn’t work because of the simple fact that you are looking back to try to see what is in front—the economy of tomorrow has no past precedent. All investment managers will have periods of outperformance because their investment style happens to coincide with favorable market factors. Likewise, they will also have periods of underperformance because the market doesn’t like their approach.
Trying to gain double digit returns is not native to market investing. They can only be created by artificial manipulations of supply and demand to create overvalued assets. This is due to several factors:
- The money supply is controlled by the Fed through interest rates and printing money. It is not based on market needs, but what is required to fulfill their agenda. Market bubbles and crashes are systematically created through the expansion, then contraction of the supply of money in the economy.
- Actual rates of return for investment funds almost always underperform their relative indexes. For example, the S&P 500 shows a 9.10% average annual return (arithmetic calculation) between 2004 and 2013. However, when the NYU Stern School of Business calculated the actual returns using all gains and losses (geometric calculation) during that 10-year period, the return is only 7.34%.
- Since no one can buy an index and must invest through a mutual fund to approximate the index, such as an S&P 500 mutual fund, investment costs must be added in. If ALL costs are included, it would be a minimum of 1% in most cases (it is usually much more). That means our S&P 500 investment would have averaged 6.34% a year from 2004 to 2013.
Therefore, if you invest in an S&P 500 fund, then your expectation should be an annual return of about 6%. That’s it! Anything over that builds up the overvaluation. After so many years, the stock prices will snap back to their true value, and you will give back the excess.
Adjust your investment return expectations down to reflect investment truths rather than marketing hyperbole.
Third, learn how to properly diversify. Diversification is allocating your assets into different types of investments to lower risk. What is the risk? Chance of loss, in any of the myriad of ways it can manifest in your investment experience. The less you diversify, the more you will feel market corrections in your overall net worth and emotional well-being.
In theory, you will want some money in assets that go up in certain market environments while other assets go down at the same time. This smooths out your volatility and makes for a less frantic ride. But don’t forget this simple fact: if you own a private practice, that IS your largest and most risky asset. As a matter of fact, it is 5-10 times riskier than the S&P 500 based on valuation methodology. To diversify properly from that amount of risk, we need to look at very low risk alternatives that focus on principal protection rather than speculative gain.
Market corrections are a positive event. It prevents (or at least delays) market catastrophes. Use them to your advantage. If you love the thrill of “buying low and selling high,” then you may want to pour in more money when prices are down and ride the wave. This can work once in a while and can be fun. If you have the rest of your financial plan in place and you are truly diversified, market corrections will have little impact on your overall financial well-being.