Should You React the Stock Market's Ups and Downs?

By Tom Madell

I find it unfortunate, but completely wired into our brain circuitry, that we over rely on often very short-term data in forming our judgments about our investments and when deciding whether we might need to adjust our portfolios. Although it is hard to realize it at the time, this almost always leads to doing exactly the opposite of the right thing if we wish to maximize our returns, or even to come out ahead at all. This may appear to be a very strong statement but is true nonetheless. And it helps account for why so many investors lost so much money in the 2007-2009 market crash.

Unless you are investing with blinders on, it should be obvious that investing in stocks takes a certain amount of guts, for the lack of better word. You are putting your money at risk, and you need to believe that your investing decisions will result in a net positive and not the other way around.

But when you see that this assumption could be turning out wrong, or is going from starting out positive to threatening to turn negative, there is the tendency to want to step in before it is too late. Unfortunately, invariably, when it comes to stocks, what usually appears to threaten your objectives from the perspective of the short term, often turns out to be, instead, favorable for the investor who can assess the longer-term possibilities.

Although true almost always, let's look at what's been happening recently in late 2017 and thus far in 2018 as examples. It once again demonstrates how some investors may read as of yet short-term market behavior in inappropriate ways, mirroring ways that many investors have typically reacted in the past.

Recent Market Gyrations

On Dec. 18th, 2017, stocks in the major indices hit all-time record highs. Over the following weeks ending Jan. 17th, as stocks continued to climb, investors added $58 billion to stock-based mutual funds and ETFs. This was the biggest inflow over 4 weeks into such funds ever; see the following article. Also, according to the article, actively-managed funds, which have seen massive outflows in the past several years, also achieved four-year high inflows over the same period.

Between Jan. 4th and mid-Jan., the Dow Jones Industrial Average jumped from 25000 to 26000, with the climb of 1000 points accomplished in just 12 days, the fastest ever for such a point gain; see here. The approximate 7.5% gain between the end of 2017 and just before the 10% correction that began on Jan. 27 was one of the biggest jumps ever to start a calendar year.

As quoted in the just cited article, "The rush of cash is inspired by a 'fear of missing out,' Michael Hartnett, Bank of America Merrill Lynch's chief investment strategist, said in a report on weekly fund flows." Apparently, then, it seemed to these investors like it could be an opportune time to capitalize on the spurt, and perhaps even a relatively safe time to invest as "confirmed" by what they were seeing. Likely, they were assuming it was a smarter time to invest than when stocks were merely drifting without direction, or as compared to when stocks are falling.

But truth be told, these investors were probably being caught up in the type of "short-termism" that my Newsletter has frequently tried to warn against. Stocks may bounce around over short periods of time while in no way necessarily reflecting long-term prospects.

When stocks begin falling, especially sharply and precipitously as we saw starting on Jan. 27, even if only transpiring over a matter of days or weeks, one can observe the tendency to extend what is true at present into the assumption that the same will necessarily be how the market is going to play out over the longer term. This too, then, is another example of short-termism. Thus, we should not be particularly surprised that, as reported in the Wall Street Journal, investors withdrew a record amount from stock mutual funds the first week in February.

As has happened so many times before, it can be seen that in the case of either rapidly rising or rapidly falling stock prices, these phenomena can generate either a mild fear of missing out in the case of the former, or a much stronger near-panic of losing money in the case of the latter. But think about it: Since one has absolutely no way of knowing if or for how long the trend might continue, acting on such fears would seem to make little sense. Rising stocks might stop dead in their tracks as we just witnessed starting Jan. 27th (although they may now be bouncing back), while falling stocks could easily reverse course making any sale turn out to be a money-losing proposition. You might as well be making your decisions based on a flip of a coin. In each case, this short-term thinking will likely defy a more reasoned approach to guide you as to when to buy and sell, regardless of the market's unpredictable bounces up and down.

And so, in this case as in others, investors jolted by fear, would have likely tried to "figure out" either through their own intuition or through other sources (e.g. advisors, "astute" commentary in the media), just what was most likely to happen next. But, as noted above, since no one, no matter supposedly how "expert" can know the answer to that, there is really little point in trying to read such tea leaves. There must be, and is, a better way to decide on if, and when, to sell (or buy) stocks.

Note that a sharply positive stock rise, such as we were recently experiencing in December and most of January, may not necessarily prove to be a bad time to invest. But those investors who hadn't considered making any move but abruptly became more optimistic as a result of a short-term spurt, should realize that no matter what the short-term gains might seem to be projecting about the future, an investment in stocks has the best chance of producing the best results when, historically, stocks are priced fairly, or better still, undervalued.

When stocks fall sharply enough, investors can see their accumulated gains start to erode or even disappear. But what they see "on paper" does not have to actually materialize unless the investor is swayed into actually selling. In many short-term market downdrafts, stocks typically claw their way back, so that "paper losses" are never made "real" unless by the investor's own ill-advised actions. Likewise, investors should not assume that their "paper gains" in a rising market will be theirs to keep. That's why getting caught up in and following what later proves to be a short-term buying "spree" by your fellow investors can turn out to be poor entry points for new investments.

So here is the main takeaway: There is no point looking back at the stock market drops or gains of the last few days or weeks and trying to figure out what comes next because no one can possibly know! Anything you see or hear about what the drops or gains foretell about the future is sheer conjecture (but it sure gives advisors, investment article journalists, and even investment newsletters plenty of new material to work with.)

Each time the market drops, your natural reaction will likely be one of disappointment, apprehension, or maybe even fear. Of course, if you were going to need an investment in its totality quite soon, it is possible there may not be enough time for you to recover your losses, and you may be forced to get whatever money back you still can. That's why money you are going to need near term should be safely out of stocks well before the period of need approaches.

Unwire Your Brain

In actuality, it is possible for investors to turn "wired" (and conventional) investment thinking that prices going up are always good and those going down are always bad, and the fears these thoughts can generate, on its ear. How?

Sure, it may seem great when stock prices and therefore your investments are heading higher. After all, isn't that your goal? But when stock prices keep climbing without any sort of correction, they may be going to unsustainable heights. Given the way the stock market works, this inevitably can lead to precipitous drops. Stock crashes, or at least serious downdrafts, inevitably occur after investors have bid prices up too much. Thus, "too much" of a "good" thing can lead to a "bad" thing.

How can you tell when a good thing may have become excessive? Unfortunately, you can't in any absolute sense, so at some point, common sense has to take over. Perhaps the best, but still imperfect, yardstick is historical averages. Since stocks historically average gains of 10% or so per year, and for the last half decade or so they are averaging say 15% or more per year, you might consider whether investors have bid up prices too high, and are therefore, likely, overvalued.

What about when prices embark or what looks like a serious fall? If you are a long-term investor, you should not fear corrections, or even bear markets. Why not? As long as you don't need your money now or, more realistically, in the next three to five years, falling prices can instead turn out to be a blessing.

Whether you are dollar cost averaging into stocks, looking for opportunities to buy more stock on the cheap, or merely holding on to a position, you are highly likely to get a bounce back from low prices, making such opportunities perhaps better times to be confident about your holdings long-term potential than when stock prices are high. Once again, historical average returns are good but imperfect yardsticks. An index that now shows, say, 5% annualized returns instead of its 10% yearly average over the last half decade or so, shouldn't scare you off; chances are it will bounce back in the years ahead and therefore represent a good investment opportunity.

Turning wired thinking on it ear may save you from investing mistakes and actually improve your long-term investment results. Thus, a correction in stock prices will likely give stocks reduced valuations as compared to when they were before the correction. And lower valuations or less overvalued stocks tend to do better over the long-term than those that turn out to be too highly priced, or even overvalued when purchased.

As it applies to the present, the recent, thus far, short-lived correction in stocks has made expensive stocks a little less expensive. But a return to new bout of over-enthusiasm for stocks, if it happens, would suggest that investors might still want to wait to better buying opportunities.

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Note: The next Newsletter is scheduled to be published at the end of March.

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