Finance

One Year Does Not a Market Make

2018 stock market

2018 was a challenging year if you have money in the stock market. The S&P 500 was down 6.2% and the DOW industrial average lost 5.6%.

If that alone isn’t enough to set nerves on edge consider this: the most market volatility since the financial crisis; the psychological effects of recency bias (the tendency to think that what’s been happening lately will keep happening) and loss aversion (we prefer avoiding losses to acquiring equivalent gains). These factors further heightened our concern.

To help me put 2018 into perspective, I started working on a podcast (how to cope with a steep market decline). When I asked my wife for some input she correctly pointed out that 2017 was an exceptionally good year for the market (DOW +25% and the S&P 500 +19%). She said that when you combine 2017 with 2018 results, things don’t look so bad. In fact, the combined 2017-18 results exceed the DOW’s average annual return of 7.8% and the S&P 500’s of 9.8%.

Here are several more things that may affect how you view 2018.

  • Both the DOW and S&P 500 pay dividends. The DOW ETF (DIA) is currently yielding 2.25% and the S&P 500 ETF (SPY) 2.04%. The receipt of dividends reduces the impact of capital losses.
  • If you practice portfolio diversification and rebalancing your losses should be less. For example, let’s assume that an investor has a portfolio valued at $200,000 at the start of 2017 with 10% in cash and short term, 50% stocks, 30% fixed income and 10% other. Let’s keep it simple just to illustrate this point. Assume that the $100,000 in stocks is invested in the DOW ETF. Since the DOW rose by 25% in 2017, the investor now has $125,000 in stock at the end of the year. Holding all other asset valuations equal, the portfolio is now worth $225,000 and stocks comprise 56% of the portfolio. In order to maintain a 50% allocation, the investor would rebalance their portfolio by selling a portion of the $25,000 gain and reallocate across all investment classes in order to maintain their asset allocation. Had they done so at the start of 2018 their losses would have been somewhat curtailed because they would have less than $125,000 exposed to the stock market.
  • Consider using the bucket strategy which separates investment types into time-based “buckets”. There are many possible implementations of the bucket strategy but for this example let’s assume three buckets. Bucket one contains one or more years of living expenses in cash and short term instruments such as money market accounts or floating rate funds. Bucket two contains three (it can hold more) years worth of expenses in slightly more risky investments such as bond and hybrid funds. Bucket three holds the most risky investments such as stocks. The psychological benefit is that when markets tank, investors are comforted by the fact that they have enough funds to cover many years of living expenses while their more risky investments have plenty of time to recover. The main challenge of using the bucket strategy is the lack of tools to manage it. The key decision is whether the added costs and complexities associated with the bucket strategy are worth the psychological benefits.
  • On average, markets are up 3 out of 4 years. So over time, the trend is up but it is not linear.

No one can deny that 2018 was a difficult year. But such years are normal in the grander scheme of things. Stock market performance, like many things in life, is out of our control. However, we are not powerless. Risk-based asset allocation, diversification, portfolio rebalancing and the bucket strategy are just a few options we have. But don’t overlook perhaps the most important way to cope – don’t put too much weight on the results of just one year!

Note: the information contained in this article is not offered as advice or guidance. Its purpose is illustrative – not instructive or prescriptive. As always, seek professional advice when it comes to your financial decisions.

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