28.02.2018

There’s No Need to Fear Stock Market Corrections

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Individual investors react very poorly to stock market corrections. Many individual investors sell when the market declines out of fear it will never come back. The data, which we will present in this post, actually says the opposite. Not only will the market come back, but it will do so a lot sooner than you might think.

As you can see from the chart below, over the past 50 years there have been 14 market corrections and 11 bear markets. The industry standard definition of a market correction is a peak-to-trough decline of at least 10% and the definition of a bear market is a peak-to-trough decline of at least 20%. For the purpose of this analysis we rounded up declines to determine corrections and bear markets.

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It Doesn’t Take That Long to Wait Out a Correction

The table below displays the size of each correction and the amount of time it took the market to recover — i.e. the time it took to return to the price achieved at the peak.

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As you can see the mean time to recovery was only 107 days, which is not that long of a time to exercise patience. Interestingly, it took on average around the same amount of time to recover as it did to decline. Yet numerous research organizations, most notably DALBAR, have found that individual investors consistently run for the exits whenever the market drops, which on average costs them 4% per year!

Wealthfront clients are not immune to this basic human instinct. But fortunately, as the data showed in Passive Investors Need Less Hand Holding, our clients are far less likely to withdraw their money than the average US investor. However among the small number of Wealthfront clients who completely closed their accounts in down markets, I found that prior to opening their account, less than 5% of them said they would sell their entire portfolio if the market dropped by 10%. Almost 50% said they would add more funds! I guess the psychological pain of a market down draft is just too strong for some people to ignore.

Bears Have Stamina

Bear markets take much longer to recover, hence the need for far more patience — yet recover they do. The mean time to recovery for bear markets was 684 days, but that was highly influenced by the six years it took to recover from the bear market in the 70s. Even the financial system meltdown in 2008 required less time to recover.

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In contrast to corrections, which took about the same amount of time to recover as they did to create their maximum losses, bear markets take twice as long to recover as it took to reach a trough. This suggests investors take longer to get over bigger losses.

It Pays to Stay Invested

As we explained in Invest Despite Volatility, if you plan on saving over the long term then even a bear market should not stop you from adding to your investment account. As a matter of fact, investing in a bear market can significantly increase the value of your holdings at retirement because, in effect, you got to buy at a discount all along the way.

Despite all the corrections and bear markets over the past 50 years, an investor who started investing on January 1, 1965 would have seen a compounded return of 6.6% over the ensuing 50 years. That’s far in excess of the compounded inflation rate of 3.6%.

It Can Pay To Fight Your Instincts

There is very little about investing that makes intuitive sense. You’re better off investing in a falling market than a rising one. You should sell your winners and buy more of the losers. You can’t time the market. Ignoring market corrections and bear markets is yet another example of an investing best practice that just doesn’t feel right. But just because it doesn’t feel right doesn’t mean you should do the wrong thing. The data is just too clear to ignore.

 


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There’s No Need to Fear Stock Market Corrections
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