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Categories
Market Volatility
How to handle market declines

You wouldn’t be human if you didn’t fear loss.


Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss aversion theory, showing that people feel the pain of losing money more than they enjoy gains. The natural instinct is to flee the market when it starts to plummet, just as greed prompts people to jump back in when stocks are skyrocketing. Both can have negative impacts.


But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies. Here are seven principles that can help fight the urge to make emotional decisions in times of market turmoil.


1. Market declines are part of investing


Over long periods of time, stocks tend to move steadily higher, but history tells us that stock market declines are an inevitable part of investing. The good news is that corrections (defined as a 10% or more decline), bear markets (an extended 20% or more decline) and other challenging patches haven’t lasted forever.


Market downturns happen frequently but don't last forever

Table with the headline “Market downturns happen frequently but don’t last forever” that shows the average frequency and length of market downturns in the S&P 500 from 1952–2021. Declines of 5% or more occur about three times per year and average 43 days in length. The last one occurred in October 2021. Declines of 10% or more occur about once per year and average 110 days in length. The last one occurred in September 2020. Declines of 15% or more occur about once every three years and average 251 days in length. Declines of 20% or more occur about once every six years and average 370 days in length. March 2020 is the last time a decline of at least 15% or 20% occurred. Sources: Capital Group, RIMES, Standard & Poor’s. Average frequency assumes 50% recovery of lost value. Average length measures market high to market low.

Sources: Capital Group, Standard & Poor’s. As of 12/31/21.

The Standard & Poor’s 500 Composite Index has typically dipped at least 10% about once a year, and 20% or more about every six years, according to data from 1952 to 2021. While past results are not predictive of future results, each downturn has been followed by a recovery and a new market high.


2. Time in the market matters, not market timing


No one can accurately predict short-term market moves, and investors who sit on the sidelines risk losing out on periods of meaningful price appreciation that follow downturns.


Every S&P 500 decline of 15% or more, from 1929 through 2020, has been followed by a recovery. The average return in the first year after each of these declines was 55%.


Even missing out on just a few trading days can take a toll. A hypothetical investment of US$1,000 in the S&P 500 made in 2012 would have grown to more than US$3,790 by the end of 2021. But if an investor missed just the 10 best trading days during that period, he or she would have ended up with 44% less.


Missing just a few of the market's best days can hurt investment returns

Chart that shows the value of a hypothetical $1,000 investment in the S&P 500, excluding dividends, from January 1, 2012, to December 31, 2021. The chart shows the ending value under five scenarios: invested the entire period, missing the 10 best days, missing the 20 best days, missing the 30 best days and missing the 40 best days. The ending values in these scenarios were $3,790, $2,108 (lost 44% of the value compared to being invested the entire period), $1,575 (lost 58%), $1,243 (lost 67%), $1,005 (lost 73%), respectively. Sources: RIMES, Standard & Poor’s. As of December 31, 2021. Values in USD.

Sources: RIMES, Standard & Poor’s. As of 12/31/21. Values in USD.

3. Emotional investing can be hazardous


Kahneman won his Nobel Prize in 2002 for his work in behavioural economics, a field that investigates how individuals make financial decisions. A key finding of behavioural economists is that people often act irrationally when making such choices.


Emotional reactions to market events are perfectly normal. Investors should expect to feel nervous when markets decline, but it’s the actions taken during such periods that can mean the difference between investment success and shortfall.


Graphical representation that shows investor emotions move in a circle. When market prices are high, investors often buy. As prices decline, they often sell.

One way to encourage rational investment decision-making is to understand the fundamentals of behavioural economics. Recognizing behaviours like anchoring, confirmation bias and availability bias may help investors identify potential mistakes before they make them.


4. Make a plan and stick to it


Creating and adhering to a thoughtfully constructed investment plan is another way to avoid making short-sighted investment decisions — particularly when markets move lower. The plan should take into account a number of factors, including risk tolerance and short- and long-term goals.


One way to avoid futile attempts to time the market is with dollar cost averaging, where a fixed amount of money is invested at regular intervals, regardless of market ups and downs. This approach creates a strategy in which more shares are purchased at lower prices and fewer shares are purchased at higher prices. Over time investors pay less, on average, per share. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.


When stock prices fall, you can get more shares for the same amount of money and lower your average cost per share

Chart is a hypothetical example that shows that when stock prices fall, you can get more shares for the same amount of money and lower your average cost per share. For each month displayed, the chart shows two bars: the price per share and the number of shares bought. The lower the share price, the higher number of shares that were bought. Source: Capital Group. Over the 12-month period, the total amount invested was $6,000, and the total number of shares purchased was 439.94. The average price at which the shares traded was $15, and the average cost of the shares was $13.64 ($6,000/439.94). Hypothetical results are for illustrative purposes only and in no way represent the actual results of a specific investment.

Source: Capital Group. Over the 12-month period, the total amount invested was $6,000, and the total number of shares purchased was 439.94. The average price at which the shares traded was $15, and the average cost of the shares was $13.64 ($6,000/439.94). Hypothetical results are for illustrative purposes only and in no way represent the actual results of a specific investment. Regular investing does not ensure a profit or protect against loss. Investors should consider their willingness to keep investing when share prices are declining.

Retirement plans, to which investors make automatic contributions with each paycheque, are a prime example of dollar cost averaging.


5. Diversification matters


A diversified portfolio doesn’t guarantee profits or provide assurances that investments won’t decrease in value, but it does help lower risk. By spreading investments across a variety of asset classes, investors can buffer the effects of volatility on their portfolios. Overall returns won’t reach the highest highs of any single investment — but they won’t hit the lowest lows either.


For investors who want to avoid some of the stress of downturns, diversification may help lower volatility.


No asset class has consistently offered the best returns year in and year out

Chart shows annual returns of seven asset classes between 2012 and 2021: U.S. large cap stocks, global small-cap stocks, international stocks, emerging markets stocks, U.S. bonds, international bonds and cash. Each year the asset classes are sorted in order of best returns to worst returns. The chart shows changeability over time among the asset classes with the best returns. Source: Refinitiv Datastream, RIMES. U.S. large-cap stocks — Standard & Poor's 500 Composite Index; Global small-cap stocks — MSCI All Country World Small Cap Index; International stocks — MSCI All Country World ex USA Index; Emerging markets stocks —MSCI Emerging Markets Index; U.S. bonds — Bloomberg U.S. Aggregate Index; International bonds — Bloomberg Global Aggregate Index; Cash — Bloomberg U.S. Treasury Bills Index: 1–3 Months.

Sources: Refinitiv Datastream, RIMES. U.S. large-cap stocks — Standard & Poor’s 500 Composite Index; Global small-cap stocks — MSCI All Country World Small Cap Index; International stocks — MSCI All Country World ex USA Index; Emerging markets stocks — MSCI Emerging Markets Index; U.S. bonds — Bloomberg U.S. Aggregate Bond Index; International bonds — Bloomberg Global Aggregate Bond Index; Cash — Bloomberg U.S. Treasury Bills Index: 1-3 Months. 

6. Fixed income can help bring balance


Stocks are important building blocks of a diversified portfolio, but bonds can provide an essential counterbalance. That’s because bonds typically have low correlation to the stock market, meaning that they have tended to zig when the stock market zagged.


High-quality bonds have shown resilence when stock markets are unsettled

Chart shows returns for Bloomberg U.S. Aggregate Index and the S&P 500 Index during six recent market declines. During the “flash crash” (April 23, 2010, through July 2, 2010) bonds increased 3.0% and stocks fell 15.6%. During the “U.S. debt downgrade” (April 29, 2011, through October 3, 2011), bonds rose 5.4% and stocks fell 18.6%. During the “Oil price shock” (November 3, 2015, through February 11, 2016) bonds were up 1.9% and stocks fell 12.7%. During the “Global selloff” (September 20, 2018, through December 24, 2018) bonds rose 1.6% and stocks fell 19.4%. During the “COVID-19 outbreak” (February 19, 2020, through March 23, 2020), bonds fell 0.9% and stocks fell 33.8%. Sources: Capital Group, Morningstar. Dates shown for market corrections are based on price declines of 12% or more (without dividends reinvested) in the unmanaged S&P 500 with at least 50% recovery persisting for more than one business day between declines. The returns are based on total returns in USD. As of June 30, 2021.

Sources: Capital Group, Morningstar. Dates shown are based on price declines of 12% or more (without dividends reinvested) in the unmanaged S&P 500 with at least 50% recovery persisting for more than one business day between declines. The returns are based on total returns in USD. As of 6/30/21.

What’s more, bonds with a low equity correlation can potentially help soften the impact of stock market losses on your overall portfolio. Funds providing this diversification can help create durable portfolios, and investors should seek bond funds with strong track records of positive returns through a variety of markets.


Though bonds may not be able to match the growth potential of stocks, they have often shown resilience in past equity declines. For example, U.S. core bonds were positive in four of the last five corrections of 12% or more.


7. The market tends to reward long-term investors


Is it reasonable to expect 30% returns every year? Of course not. And if stocks have moved lower in recent weeks, you shouldn’t expect that to be the start of a long-term trend, either. Behavioural economics tells us recent events carry an outsized influence on our perceptions and decisions.


It’s always important to maintain a long-term perspective, but especially when markets are declining. Although stocks rise and fall in the short term, they’ve tended to reward investors over longer periods of time. Even including downturns, the S&P 500’s average annual return over all 10-year periods from 1937 to 2021 was 10.57%.


Chart shows rolling 10-year average annual total returns for the S&P 500 from 1937 to December 2021. The average return was 10.57%. The average annual return for the 10 years ending December 31, 2021, was 16.55%. Sources: Capital Group, Morningstar, RIMES, Standard & Poor’s. As of December 31, 2021.

Sources: Capital Group, Morningstar, Standard & Poor’s. As of 12/31/21. Returns are in USD.

It’s natural for emotions to bubble up during periods of volatility. Those investors who can tune out the news and focus on their long-term goals are better positioned to plot out a wise investment strategy.



Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the results of approximately 500 widely held U.S. common stocks. 

 

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