How to Think about Stock Market Drops
On Tuesday, October 9, 2018, the Dow Jones Industrial Average (DJIA) stood at 26,430. By the closing bell on Thursday, October 11, it had fallen more than a thousand points. On Thursday alone, the DJIA dropped more than 800 points, or 3.15 percent of its value, to close at just over 25,000. During that same period, the much broader Standard & Poor’s (S&P) 500 index fell by a similar percentage. Then, on October 24, the DJIA fell another 600 points, and the S&P was off more than 80.
The cycle of ups and downs—including some sizeable drops in stock prices like the ones we have seen in October—is nothing new, of course. Any time the financial markets do anything dramatic, whether on the upside or the downside, market analysts and financial columnists line up on both sides, providing data that corroborates their views: that this latest move is evidence either of a pending downdraft in the market or that it is a sure sign of higher market peaks to come. Much of the time, these opposing views are pointing to the same data as proof of their predictions. In other words, they are looking at the same market statistics and coming to opposite conclusions about what the numbers mean. Of course, this can be very confusing for the average investor.
As we view the current market environment, it’s important to remember several things. First, an 800-point drop in the DJIA, though it sounds dramatic, does not mean the same thing that it meant in years past. On October 11, the DJIA stood at just over 25,000, so an 800-point drop, while not insignificant, represents only about 3 percent of the value of the index. By contrast, during October 1929, the stock market lost some 36 percent of its value. Because the DJIA at that time stood at slightly less than 400 at its peak, the disastrous decline was only about 137 points—a change that would be little more than a blip in today’s average of well over 20,000. In other words, a large point decline in the DJIA doesn’t mean the same thing today that it did in years past, when the value of the index was much lower.
Second, it’s helpful to remember that the DJIA, though it is by far the most familiar market indicator, is actually a fairly narrow index. It is composed of the cumulative stock prices of thirty of the largest publicly traded companies in America. By contrast, the S&P 500 index, also a fairly well-known financial indicator, consists of a weighted average of the market capitalizations of about 500 large, publicly traded U.S. companies. Most analysts consider the S&P 500 to be a much more broadly based and indicative measure of stock price movement. Certainly, the S&P 500 tends to move largely in parallel with the DJIA, but it’s worth remembering that the DJIA average is much less representative of American business as a whole.
Finally, investors should always keep in mind that just as stock prices rise, they also fall; such movements are an unavoidable part of investing in the stock markets. The 800-point drop on October 11, for example, was entirely within the normal range of a mini adjustment, which we’ve experienced numerous times since March 9, 2009, the date many analysts use as the “official” beginning of the latest bull market.
Of course, stock prices in the aggregate have always eventually risen farther than they have fallen. Over the ten years ending in September 2014, for example, the S&P 500 returned an average of just over 8 percent, while the bond market, during that same period, averaged a return of just 4.6 percent. But what about the longer term? Well, since 1927, U.S. stocks have delivered an average annualized return of just over 10 percent—despite major downturns like the Great Depression of the 1930s and the Great Recession of 2007–2009. By comparison, from 1927 to 2017, bonds have provided an annualized total return of about 5.4 percent.
A recent communication from Dimensional Fund Advisors contains some very good advice for investors who may be concerned about stock market fluctuations.
If one were to try and time the market in order to avoid the potential losses associated with periods of increased volatility, would this help or hinder long-term performance? ... It is unlikely that investors can successfully time the market, and if they do manage it, it may be a result of luck rather than skill. Further complicating the prospect of market timing being additive to portfolio performance is the fact that a substantial proportion of the total return of stocks over long periods comes from just a handful of days. Since investors are unlikely to be able to identify in advance which days will have strong returns and which will not, the prudent course is likely to remain invested during periods of volatility rather than jump in and out of stocks. Otherwise, an investor runs the risk of being on the sidelines on days when returns happen to be strongly positive.
In our work with clients, we strongly affirm this point of view. Emotional responses to market fluctuations almost never turn out well, in terms of long-term returns. Instead, careful diversification and consistently remaining invested, along with attention to each client’s goals, needs, and level of risk tolerance, have proven to be the most reliable ways to build wealth for important goals.
Don’t let the market pundits and their click-bait headlines distract you from meeting your long-term goals. If you would like to develop a financial strategy that is tailored to your specific needs and characteristics, a professional, accredited financial adviser can provide time-tested, evidence-based assistance that places your needs as the first priority.