Warren Buffett once quipped that, “It’s only when the tide goes out that you discover who’s not wearing a bathing suit.”
I’ve been thinking about this idea over the past week, as markets around the world have given up all their year-to-date gains, and then some. Since peaking at the end of January, the U.S. market, as measured by the S&P 500, has lost more than 10 percent of its value.
When the tide goes out like this, the emotional impact can be powerful — and oftentimes the headlines just make it worse. All this week, in fact, my phone has been lighting up with alerts like, “DOW DROPS 600 POINTS, ON TRACK FOR WORST WEEK SINCE 2009.”
The advice from industry experts is less sensational but often so convoluted that it’s hard to know what to make of it. This, for example, was the comment this morning from one Wall Street analyst: “I know SPX corrects in about 5.56 percent increments so that would be the 200-day moving average or about 2,540 with some room for modest overshoot.”
And, it’s not just Wall Street types who are weighing in now. On the radio this morning, the local DJ spent time gloating over a recent stock sale. “I feel like a semi-genius,” he kept repeating. “I’m a winner.”
If you are struggling to make sense of the headlines and the crosscurrents of commentary, here’s what I might recommend:
Maintain perspective. Yes, the market has seen a sharp drop-off in recent days, and it may continue. But, prior to this week, the market had increased more than four-fold since 2009. This week’s losses really just turned the clock back to prices we saw as recently as Thanksgiving. This is important to recognize because you don’t want to feel paralyzed by what’s going on. Importantly, if you had been thinking of rebalancing your account, to reduce your risk exposure, this week’s losses shouldn’t stop you. In fact, market corrections like this are a good reminder that you should never try to “time the market.” In other words, if you have a plan in mind, stick to it; don’t drag your feet, hoping for a better price tomorrow.
Recognize that biology is working against you. Research by the behavioral economists Daniel Kahneman and Amos Tversky revealed an important fact about human psychology: We dislike losses much more than we enjoy gains. Roughly speaking, they found a 2-to-1 ratio. In other words, we would have to gain two dollars to make up for the loss of just one dollar. That’s why the headlines last year were so quiet while the market was gaining an impressive 22 percent. But, when the losses started last week, suddenly the headlines switched over to ALL CAPS. Unfortunately, this loss-aversion is just the way we are wired. Sometimes things are as bad as they seem, but oftentimes they are not, and you want to avoid overreacting. That’s why it’s useful to be aware of the preference that our internal systems have for seeing the negative.
Look at the market through your own lens. Try your best to tune out the headlines and instead to focus only on your own financial picture. If you have a well structured financial plan in place, the daily movements of the market should be irrelevant to you. In fact, if you are at a point in your career when you are saving, you might welcome a market pullback. It allows you to buy at lower prices.
Remember that the stock market isn’t just a giant slot machinethat produces only random and unpredictable results. Yes, there is a lot of emotion that causes prices to gyrate. But, when you strip out that emotion, there’s actually a fairly simple formula that underlies the prices of stocks. In technical jargon, it’s called discounted cash flow. Or, in the plainspoken words of Warren Buffett, it’s the value of all the cash that a business might generate during its remaining life. So, as long as the population grows, and businesses innovate and become more productive, there is a logical reason why you should expect stock prices to increase over time. It may not happen every year — and if we’ve gotten more than we deserve in recent years, we may have to give some back — but over time it is logical to expect the market to go up.
No one knows what the market will do next week or next month, but my hope is that these ideas can help you weather it with greater peace of mind.