STOCK MARKET CORRECTIONS

Today, the media has been full of news of a dramatic fall in stock markets around the world with one measure of the US S&P 500 stock market falling by 4.6% in one day. The drama could lead you to believe that you should start selling your investments (or avoid them in the first place). Is this true? We examine the truth about stock market corrections.

Key points

  • What are stock market corrections?
  • Stock market corrections are regular, but usually short-term
  • Can you avoid stock market corrections?
  • How to prepare for stock market corrections

What are stock market corrections?

Stock market corrections happen when the market falls by 10% or more from its 52 week high, over a period. This is different to a stock market crash, when a market falls by 10% of more in one day. This is a normal part of investing, and professional investors almost welcome these corrections. Generally, the trend of stock markets is upwards, so a correction can be a sign that the market is pausing for breath, before rising again. Statistics show that a stock market correction takes place on average around once per year, and most do not turn into negative bear markets.

Stock market corrections happen regularly, but are usually short-term

Stock market corrections are inevitable. If you invest money in an attempt to grow your capital or income faster than the cost of living, then unfortunately you have to get used to market movements. You should not fear stock market movements, but you should be prepared for them.

Stock market corrections tend to be short-term in nature. Generally, an event trigger a quick and severe market movement, but if the fundamental economy is in good shape then the market usually recovers.

These market movements are known as volatility – that is the fluctuation in the value of your assets over a specific period. Our clients know that we have been commenting for some time about the relatively low volatility in the UK stock market (compared to recent averages). This has been helped by the fact that stock markets have been on a general positive run for a few years. Within this context, any short-term fluctuation in stock markets is normal, and to be expected.

Example – The EU referendum result

When the EU referendum result was announced in the UK on June 23rd 2016, the UK stock market immediately dropped in value, partly because the market was not expecting this outcome.

Here are the values for the FTSE All-share index of UK shares:

  • June 23rd 2016 –  5,680
  • June 28th 2016 – 5,426 (fall of 4.5%)

This was not technically a stock market correction, since the stock market did not fall by 10%. In fact, the drop in value proved to be short-lived. Politicians and the central bank quickly moved to add money to the system, and the stock market reached 5,737 by the 30th of June. The event proved to be a short-term episode of stock market volatility rather than a correction.

Some context

Obviously, stock markets move daily, so statistics will change. However, at the time of writing (6th February 2018) the US stock market (S&P 500) has fallen by 4.6% in one day, and 7.5% from the market high on 11th January 2018. However, even with these falls the US stock market remains up over 1 year with gains of 4.9%.

Can you avoid stock market corrections?

Unfortunately, it is impossible to avoid stock market corrections with any degree of certainty. Some investors try to do this, but only manage to achieve this through a vary high degree of speculation, which in turn extends the risks they take.

Studies of investing show that any attempt to time the market is likely to result in lower returns. This is partly because it is impossible to predict events, and also because the stock market moves so quickly. Any delay in investing while waiting for the perfect time to invest, can mean that you lose a large slice of the gains for a particular year.

How to prepare for stock market corrections

If stock market corrections are inevitable, what can you do to manage your investment approach sensibly?

Invest for the long-term

Investment studies show that the longer the period you invest over, the lower the likelihood that you will lose your initial capital. Surely the loss of capital should be more important to you than the short-term fluctuation in the value of your capital (volatility). It is more important to consider the value of your investments when you need to access them, rather than any given value on a particular day. You should consider the duration you are prepared to invest, and manage the risks you take as you get closer to withdrawals.

Diversify investments to minimise the impact of stock market corrections

All of our clients hold a wide variety of investment types, locations, and amount of holdings. This spreads the risk into investments that perform differently at different points in the cycle. This approach generally tends to lower the risks of investing so that you can manage the effects of short-term volatility. As an example, all of our clients’ investments rose in value after the EU referendum result referenced above. Of course, this cannot be guaranteed to be repeated, but in general we would expect a well-diversified investment portfolio to control short-term fluctuations in the stock market. Diversification generally does not rule out short-term losses, but it is likely to mean that any short-term losses are minimised,

A typical investment portfolio managed by us might have 15 investment sectors, with each fund containing 50-200 underlying holdings. Therefore, our clients might hold around 1,500 investments in their portfolio. The recent Carillion collapse shows the value of investment diversification.

Rebalance regularly

Stock market corrections show the value of rebalancing your investments regularly. This is a standard part of our Prosper service since it is so important. Market movements can mean that your investments get out of line with the ideal over time. Imagine that you held a simple investment strategy of 50% of your investments in a bank account, and 50% in shares. Over a period of time your shares might move up, or down, dramatically, while you would expect the bank account to be slow-moving. Rebalancing your holdings is a way to bring them back into a more correct position, and therefore manage your risks.

Review investments regularly

You should review your investments regularly, but not too regularly. This means bringing the investments back into line with your goals, and the risks you are prepared to take (or need to take). If you monitor progress too often, you will focus too much on the short-term volatility, rather than the end goal of providing the capital you need to secure your future.

What should you do now?

If you are invested in a professional, diversified investment portfolio, then the answer is probably to do nothing, unless you plan on accessing your money in the very short term. If your investments are not properly diversified, or you have a shorter investment term, then now might be the time to review your investment position. Feel free to contact us to discuss your position.

 

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Dan Woodruff

Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.