Reacting to market declines

Nothing ignites the fear of losing one's hard-earned money like a violent, short-term stock market correction. For many investors — even those with a long-term perspective — the natural human reaction to a sudden plunge in the stock market is to reduce or liquidate one's exposure, with the goal of trying to stem further loss of capital and soothe a rattled mind.

Since 1926, the stock market had a positive return in 58 out of 81 calendar years-or nearly three out of every four years. Because the long-term trend of the stock market has been upward, one must also recognize that there are significant opportunity risks accorded with trying to accurately time the market's peaks and valleys in search of outsized gains. The odds are stacked against successfully timing short-term market fluctuations, particularly because long-term investors must also effectively time their re-entry.

An examination of historical flows to U.S. stock mutual funds and the performance of the U.S. stock market reveals that, on average, individual investors have done a poor job of market timing. In general, they tended to increase their exposure to stocks just prior to a sell-off, and reduce their holdings ahead of a period of stellar appreciation. For example, investors allocated a record $219 billion in net new money to stock mutual funds during the 12-month period ending October 31, 2000, which preceded a decline of 27% for the S&P 500® Index throughout the following year. Another example of poor timing took place soon thereafter. After three straight years of stock market declines, flows turned negative (redemptions exceeded sales) during the 12-month period to February 28, 2003. However, from that point on throughout the next year, the S&P 500 rallied 35%. In other words, most investors were selling out of equity funds prior to a significant rebound and at exactly the time when they would have benefited the most by owning a higher percentage of stocks.

Some of the best periods to have entered the stock market have been during periods of particularly gloomy sentiment and market turbulence. Since 1926, the best five-year return in the U.S. stock market began in May 1932-in the midst of the Great Depression-when stocks rallied 367% (See table below). The next best five-year period (when the stock market rose 267%) began in July 1982 amid an economy in the midst of one of the worst recessions in the post-war period, featuring double-digit levels of unemployment and interest rates. Investors might use these lessons from history to remember that staying fully invested can give them an opportunity to fully participate in the market's long-term upward trend. Waiting until the backdrop feels "safe" to make an investment in stocks has historically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.

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