Should You Sell After a Correction?

Talk about a rollercoaster. Stock prices in markets around the world fluctuated dramatically for the week ended August 27. On Monday, August 24, the Dow Jones Industrial Average fell 1,089 points–a larger loss than the “Flash Crash” in May 2010–before rallying to close down “just” 588 points. Prices fell further on Tuesday before recovering sharply on Wednesday, Thursday, and Friday. Although the S&P 500 and Dow Blog.2015.10.05.V2Jones Industrial Average both ended the week’s wild ride up 0.9% and 1.1%, respectively, many investors found the dramatic day-to-day fluctuations unsettling, even stomach turning.

Here’s the thing — We so often equate a volatile market to a rollercoaster. However, once the terrifying amusement park ride comes to an end, you get off, struggle for a moment to find your footing, and carry on. Yet, when the market behaves in a frightening fashion, it’s often the worst time to exit. Even if when the dust settles we are in “correction” territory.

What’s a correction? Based on closing prices of the wild week that was, the S&P 500 Index declined 12.35% from its record high of 2130.82 on May 21 through August 24. Financial professionals generally describe any decline of 10% or more from a previous peak as a “correction.” But what should you do with this information? Should you seek to protect yourself from further declines by selling? Stay the course? Or should consider the drop an opportunity to purchase stocks at more favorable prices?

In Should Investors Sell After a Correction?” Weston Wellington, Vice President at Dimensional Fund Advisors, offers valuable perspective. He writes, “Market timing is a seductive strategy. If we could sell stocks prior to a substantial decline and hold cash instead, our long-run returns could be exponentially higher. But successful market timing is a two-step process: determining when to sell stocks and when to buy them back. Avoiding short-term losses runs the risk of avoiding even larger long-term gains. Regardless of whether stock prices have advanced 10% or declined 10% from a previous level, they always reflect two things–the collective assessment of the future by millions of market participants and the expectation that equities in both the US and markets around the world have positive expected returns.”

Contrary to the beliefs of some investors, dramatic changes in security prices are not a sign that the financial system is broken but rather what we would expect to see if markets are working properly. In fact, and the bold type here is intentional, US stocks have typically delivered above-average returns over one, three, and five years following consecutive negative return days resulting in a 10% or more decline. Results from non-US markets are similar.

Wellington concludes that the world is an uncertain place. “The role of securities markets is to reflect new developments–both positive and negative–in security prices as quickly as possible. Investors who accept dramatic price fluctuations as a characteristic of liquid markets may have a distinct advantage over those who are easily frightened or confused by day-to-day events and are more likely to achieve long-run investing success.” That is, volatility is part of the game, not something totally unexpected to be feared. And, given that properly diversified portfolios are built to withstand volatility, swings like we’ve experienced lately should be viewed as a bump in the road rather than the end of the ride.

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