Behavioral Finance

Corrective Behavior

How should investors prepare for a possible correction?

A drop of 20% in just over two months? Yowza! But what if a recovery came just as fast—and the rally continued from there, with your portfolio gaining over 24% on the year? While it’s a rough ride, the reward seems to compensate you for the bumps. This situation isn’t hypothetical, it’s historical. In 1998 the MSCI World rose 24.3% despite a big correction in the year’s second half. As nauseating as corrections are, failing to time one and missing out on bull market gains is typically more harmful to your portfolio in the long run. Today, some investors look at this bull warily—after a big 2013, surely a pullback (or worse) must lurk around the corner, they posit. But letting fears the market has risen “too far, too fast” skew you from your long-term goals is an error you can easily regret for many years to come.

Too far, too fast” fears suggest last year’s relatively smooth ride to powerfully positive returns means a correction or worse looms. 2013’s large stock gains caught many investors off guard, especially when headlines decried so-so US and global economic growth. To them, strongly positive returns suggest the stock market is removed from reality—a pullback would correct this. The result: a temptation for investors to become more “conservative” or “lock in gains”—at least until the impending correction passes. Or, alternatively, those sitting on a pile of cash they plan to invest may just flat out wait.

It would make sense to get in and out of stocks if you could predict exactly when a correction will begin and end—but we’re aware of no one with a documented track record of successfully doing so. Driven by sentiment, not fundamentals, corrections can end as quickly as they come. For example, persistent eurozone jitters contributed to corrections in 2011 and 2012: Would the single currency system fragment? Yet when reality proved better than investors realized—no split happened—markets quickly bounced and the bull marched on. More recently, many attribute January’s (non-correction) dip to Fed policy and turmoil in some Emerging and Frontier Markets. But these factors still exist today—yet stocks are inches from all-time highs. Corrections are always possible—they’re a normal, healthy bull market feature. But nothing makes a correction “inevitable,” and there is absolutely no consistency to their timing.

As of 3/19/2014, 653 days have passed since the final day of the last correction—nearly two years. How does that compare to historical periods between corrections? 2012’s correction was only 115 days after 2011’s ended. 1,154 days elapsed between 2003 and 2006’s corrections—during which the S&P 500 gained 74%.i But during the 1990s decade-long bull, there were three corrections total: 1991, 1992, and 1998. The beginning of 1992 saw a correction—only 140 days after 1991’s ended. However 2,294 days passed between the 1992 and 1998 corrections—over six years! And a whopping 179% of upside.ii Can you find a pattern? We can’t. But that’s the point—there is no predictable timeframe in which a correction “should” occur.

Trying to game the next correction is essentially a guess at what may happen. Leaving the market because of that possibility means missing out on gains while on the sidelines. Which could mean leaving a lot of money on the table—especially if you don’t return to the market for a while. Just think of the investor who sold thinking stocks had come too far, too fast in 1993. Or after 1995.

For the long-term investor, the best way to navigate a correction is to simply endure it, in our view. Yes, it will be uncomfortable and even painful. But exiting the market after a correction begins is worse. Sharp declines can be followed by similarly steep rises—and if you’re out of stocks during those bounces, you miss a chance to recover. (Some tried to time the last bear’s bottom—and got whipsawed in the process. Some still sit on the sidelines even now, waiting for that ever-elusive all-clear, and now face the difficult decision of how to correct the inaccurate timing.) The only way timing these moves works is to buy back in lower. But fear and stock prices are negatively correlated—those lower levels are likely periods of greater fear.

For long-term, growth-oriented investors, reacting to a short-term fear is all too frequently an error. It is dangerous to your financial health to make investment choices based exclusively on the possibility of some short-term negativity. It’s better to grit your teeth and invest for what’s probable. Most often, that means your allocation should be aligned with your long-term goals and objectives. Getting short-term correction timing right is a small payoff when you consider the enormous risk of being wrong for too long.

i Source: Factset. S&P 500 Total Return from 3/12/2003 to 5/9/2006.

ii Source: Ibid. from 4/8/1992 to 7/20/1998.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.