Pullbacks are unnerving, but they’re a healthy part of the economy. Sometimes a setback is necessary to move forward and progress. Here are a few reasons why:
- Pullbacks happen so frequently and are so unnerving to the average investor, they “force” the stock market to be more generous than alternative investments. People buy stocks at earnings multiples which are designed to generate average future returns considerably higher than, say, cash or municipal bonds—and investors require that “risk premium” to get on that ride. If you’re going to take more risk, you should expect at least the opportunity to get considerably more reward.
- The stock market roller coaster is unsettling for some investors, who panic sell when they experience a market lurch. This gives long-term investors the opportunity to buy stocks at a discounted price. That, in turn, lowers the average cost of the stocks in your portfolio, which can be a boost to your long-term returns.
The current market downturn relates directly to the first reason, where you can see that bonds and stocks are always competing with each other. Monday’s 4.1% decline in the S&P 500 coincided with an equally-remarkable rise in the yields on U.S. Treasury bonds. Treasuries with a 10-year maturity are now providing yields of 2.85%–hardly generous, but well above the record lows that investors were getting just 18 months ago. Bond rates go up and the very delicate supply/demand balance shifts, at least temporarily, in their direction, and you have the recipe for a stock market correction.
Is it possible that the markets drop further? Or, as is more often the case, they may rebound after giving us a pullback that stops short of a 20% downturn. Once it’s over, no matter how long or hard the fall, you will hear people say that they predicted the extent of the drop. So now is a good time to ask yourself: do I know what’s going to happen tomorrow? Or next week? Or next month? Is this a good time to buy or sell? Does anybody seem to have a handle on what’s going to happen in the future?
Take out a piece of paper and write down what you think will happen and pull them out a month or two from now. Chances are, you’re like the rest of us. Whatever happens will come as a surprise, and then look blindingly obvious in hindsight. All we know is what has happened in the past. Today’s market drop is nothing more than a data point on a chart.
Stay Diversified, Stay YOUR Course!