As of this writing, most major world stock markets are down over 10% from their highs.
When the market is up you are taking away from future returns, when the market is down you are adding to future returns.
Since 1928, these 10%+ corrections have occurred over 28 times. Many people falsely believe that these can be predicted and avoided, and if so, will lead to better long term returns. Unfortunately, market timing requires two acts of fate: selling out at the right time and buying at the right time – an elusive strategy since many of the best days in the market occur shortly after the worst days in the market.
However, this doesn’t mean we cannot keep healthy amounts of cash in the portfolios waiting for these buying opportunities. As mentioned in my August 2015 newsletter, we can expect an average 10% pullback roughly every 11 months or so. And here are some interesting numbers of what things look like 1, 3 and 5 years after 5% and 10% pullbacks:
* Source: www.ifa.com
As we can see, after 5% and 10% declines, the markets have been positive on average 12 months later. What’s more interesting is that statistically, the further the market drops, for example a 30% decline, the probability increases for it to rise over the next five years.
One important thing to note, any money that may potentially be required over the next 3-5 years should be in less volatile, non-market related investments (i.e. cash and fixed income). This allows us to have a long term view on the equity component of the portfolio. We avoid being forced to sell at inopportune times.
So why are 10% corrections good for long term returns? Because they present us with great opportunities to add to our portfolios and increase the probability of having better long term returns.