Putting a Big Stock Market Drop in Perspective

I have so many things to post about today, I doubt I’ll get to them all.

However, I couldn’t let the day close without commenting on the big financial news, namely the fairly large drop in global stock markets today. The AP Wire has a nice summary of the financial metrics from the day:

It began Monday with a 9 percent slide in Chinese stocks, which came a day after investors sent Shanghai’s benchmark index to a record high close, setting the tone for U.S. trading Tuesday. The Dow began the day falling sharply, and the decline accelerated throughout the course of the session before stocks took a huge plunge in late afternoon as computer-driven sell programs kicked in, and also as a computer glitch caused a delay in the recording of a large number of trades.

The Dow fell 546.20, or 4.3 percent, to 12,086.06 before recovering some ground in the last hour of trading to close down 416.02, or 3.29 percent, at 12,216.24, leaving it in negative territory for the year. Because the worst of the plunge took place after 2:30 p.m., the New York Stock Exchange’s trading limits, designed to halt such precipitous moves, were not activated.

In the grand scheme of things, today’s move in the stock market was neither unusual nor extremely worrisome for a long term inventor with a well thought out asset allocation. However, people are not rational with money, and loss aversion is one of the best documented aspects of behavior finance. Most research available on the topic demonstrate repeatedly that people tend to value the loss of a dollar three times more than the gain of a dollar. It’s amazing, really. The joy you likely feel seeing your portfolio up $1000 is likely 1/3 the pain you feel when you see it drop $1000. That is not a recipe for rational decisions.

I’ll be writing my next article in my personal finance education series soon, most likely on the topic of asset allocation and long term investing. Days like today can be extremely stressful if you are in the stock market for the wrong reasons, with the wrong goals, or with the wrong expectations. However, days like today can be a blessing if they force you to really embrace what risk really means in terms of the day-to-day unpredictability of the stock market.

In the meantime, however, I’d like to share an article written today by Vanguard, the puts market volatility like today’s in perspective. Here are a few lines that I felt were extremely well put:

“There’s no doubt that a big drop in stocks can be tough on your nerves and your account balance,” said Gus Sauter, Vanguard’s chief investment officer. “But after a day like Tuesday, it’s more important than ever to maintain a long-term perspective…”

Tuesday’s decline put the stock market’s return so far in 2007 into negative territory. But over the past 12 months, the broad stock market has still produced a total return—price appreciation plus dividend income—exceeding 10%. That gain, coincidentally, is roughly the long-term average annual return for U.S. stocks….

“We’ve had a very nice rebound in stocks since the long bear market that began in early 2000 and stretched into 2002,” Mr. Sauter said. “So it’s not surprising to see a pullback…”

As investors digest the volatility of the market and the flood of commentary that always accompanies such events, it may be helpful to reflect that no one can say whether stocks will continue to decline or whether they’ll soon rebound. What is clear is that few, if any, investors have a demonstrated ability to consistently pick the right times to get in—or out—of the markets…

“The stock market never goes straight up,” Mr. Sauter said. “To be a successful investor over the long term, you need to understand this fact and you need to react rationally when the market doesn’t go your way.

Successful investing is a rational, not an emotional, pursuit. If you’ve made conscious, deliberate decisions based on your personal financial goals, time horizon, and your tolerance for risk, there’s no reason to change your plans.”

One of my favorite pieces of advice that I give about investing is that for most people, you know when you are doing it well because it will be boring. For people who do not make their living in the financial markets, it should take very little time to pick a well-balanced, diversified portfolio of assets, and then add money to it regularly. Rebalance once, maybe twice, a year, and you are done.

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