Market declines are not the exception. They are part of investing. And yet it is exactly when a portfolio loses part of its value over a few weeks that the temptation to change something is strongest.
Sell. Move the money into safer assets. Wait until things calm down. Or, on the contrary, use the decline to buy quickly.
Neither of those reactions is necessarily right.
If your investment strategy is built around your goals, your horizon and the liquidity you need, a market decline on its own is usually not a reason to change it. It is more a moment when it becomes clear whether the strategy was set up well.
How often do markets fall?
Red numbers on an investment account can feel like an extraordinary event. History shows something else.
A correction is usually defined as a decline of at least 10% from a previous high, a bear market as a decline of at least 20%. According to data from Charles Schwab the US equity market went through 27 corrections from November 1974. Only six of them went on to become a bear market.
Fidelity notes that over the past 150 years declines of 20% or more occurred on the US equity market roughly once every six years on average.
That does not mean the next decline will look like the previous ones. Historical data cannot predict its depth or its length. What they do show is that fluctuation is not a malfunction of the market that would call for a new investment plan every time. It is a feature of investing that the plan should allow for from the start.
Why does the value of a portfolio fall at all?
The price of an investment does not only reflect how companies or economies are doing today. Markets continuously price in what investors expect of future profits, interest rates, inflation, economic growth and political and geopolitical risk. When expectations change, prices can react very quickly.
The reason for any particular decline is therefore different each time. Once it is interest rates, another time a recession, a pandemic, a geopolitical conflict or concern that equities are valued too highly.
For a long-term investor another question matters more: has anything changed about the reason the money is invested?
If the portfolio is funding a goal ten or twenty years away, a few weaker months mean something different from what they mean to someone who will need a substantial part of their wealth next year. The Czech National Bank, too, stresses the relationship between the length of the investment horizon and the ability to bear fluctuations in value along the way.
What we check when markets fall
A market decline is not a reason to ignore the portfolio. It is a reason to check whether it still matches the plan.
First we look at whether the client’s situation has changed. Do they need part of the money sooner than originally expected? Has their income, their business or their family situation changed? Is the moment they start drawing on the portfolio closer?
If the goal or the horizon has changed, adjusting the strategy may be appropriate regardless of what markets are doing.
The second question is the structure of the portfolio. Different parts develop differently and the original proportions between them shift over time. That is why we work with rebalancing, a return of the portfolio to the intended allocation.
The US SEC describes rebalancing precisely as restoring the original allocation after the individual parts of a portfolio have performed differently. So it is not a guess about which asset will rise next month. It is about maintaining the level of risk the plan is built on.
What we do not do when markets fall
We do not change a long-term strategy just because the headlines have changed.
When markets fall sharply, the reason for concern is usually very specific and convincing. That is exactly why prices are falling. Waiting to return to the markets until things are calm again has one problem: markets can start rising before the uncertainty disappears.
The investor then has to get two decisions right, when to step out and when to come back. That is considerably harder than sticking to a plan set in advance.
We also do not automatically buy every time the market falls. Buying can be part of rebalancing or of putting new money to work, but it should follow the strategy and the target structure of the portfolio, not a feeling that investments are on sale.
A decline means one thing for an investor and another for someone drawing an income
There is one situation where a market decline is considerably more sensitive: when you are just starting to withdraw from the portfolio regularly.
An investor who needs no money for the next fifteen years can afford to wait and see. Someone who funds their monthly expenses from investments needs the money whether markets are rising or falling.
If they have to sell during a decline, they sell at a lower price and at the same time reduce the capital that can take part in any later recovery.
That is why a portfolio meant to provide an income is planned differently from one in the accumulation phase. We have written about it in detail in Income from investments: how much wealth you need and how to set up withdrawals.
A good strategy shows itself in a bad year too
When markets are rising it is easy to feel that a portfolio is working. The real test comes when its value falls.
If at that moment you find you need to sell investments because the money will be needed soon, the problem may not be the decline itself. The portfolio may have been set up with too much risk for your horizon from the beginning.
And if the way the portfolio moves pushes you to change strategy at every significant market move, it is worth checking again whether its risk really matches what you are willing and able to accept over the long term.
At Melior Invest we therefore do not manage a portfolio according to whichever topic dominates the financial news. We build the investment strategy around what the wealth is for, when you will need it and how much fluctuation you can afford to accept.
If you already invest and want to know whether your current portfolio matches your long-term plans, we can look at it together.
