Thought Leadership in Action

A correction in more than half of the S&P 500 could be bullish

After the stock market’s historic growth that began in early 2009, many believe a 10% pullback may be a healthy thing. Such a drop is not horribly painful, by historical standards, and smart investors can cushion such a fall.

Why is a market correction beneficial? Because it prevents another bubble from forming. Bubbles occur when stock prices get clearly out of line with the earning potential of the underlying companies. We saw the consequence of that in the awful 2000-02 and 2008-09 market wipeouts, when some people lost half their wealth or more.

Certainly, market corrections never feel healthy when they occur. People get fearful as the market declines, the media fan the flames by giving investors reason after reason to be afraid, and worries that this is the beginning of the next crash begin to develop.

While many investors admit that a 5% pullback is manageably unpleasant, concerns expand when the market decline hits 10%. That’s what customarily constitutes a correction. In the most recent sell-off, from Sept. 18 to Oct. 15, the Standard & Poor’s 500 index fell 7.4%. We had a ways to go before we touched the correction mark. Since then, the market rebounded and now trades above its mid-September level.

Ben Carlson, an institutional investment portfolio manager, looked at the S&P data going back to 1950, and found 28 instances when stocks fell by 10% or more. Thus, on average, the market has entered an official correction every 2.25 years. The last market correction occurred in 2011, so another 10% drop in the near future seems reasonable.

S&P 500 Losses of 10% or More Since 1950:

Total Occurrences: 28 TimesAverage Loss: -21.6%Median Loss: -16.5%Average Length: 7.8 MonthsGreater Than 20% Loss: 9 TimesGreater Than 30% Loss: 5 TimesAs you can see, the average post-1950 market correction lasted just under eight months and the median total loss was 16.5%. What about deeper declines? Of the 28 times the S&P 500 decreased by 10%, the market suffered a loss greater than 20% – the standard definition of a bear market – only nine times (32% of the time), and a loss greater than 30% only five times (18%). The data confirm that, although these types of large losses do occur, they really are the exception.

Are you thinking: “I don’t think I can stomach that median loss of 16.5%?  Then that’s where the wisdom of diversification becomes apparent. Remember that the data above represent the historical performance of the S&P 500, an index composed of 100% stocks.

A capable financial advisor ensures you have an asset allocation mix of stocks, bonds and cash that represents your tolerance for risk. Consequently, your portfolio likely isn’t 100% stocks. In fact, the appropriate allocation for an average investor approaching or already enjoying retirement might be closer to only 50% stocks. This means that on average, your portfolio should decline only half as much as the S&P 500 during market downturns.

So diversification brings the our sample investor endured, with a 50% stock portfolio, down to around 8.25% during the median decline. Are you now back in the “manageably unpleasant?  range?  If so, you likely have an appropriately constructed portfolio. If not, you may need to reevaluate your risk tolerance to ensure you are not exposing your nest egg to a larger loss than you can endure.

Although the recent market pullback produced lots of fear, we’ve been here before. The S&P 500 declined in value by 18.64% over a five-month period in 2011. However, investors with a 50% stock portfolio likely only saw their account values drop around 9% to 10% – still not fun, but manageable.

Article written by A Lon Jefferies, CFP, MBA. AdviceIQ has an agreement to republish this author’s content. © 2018 AdviceIQ. All rights reserved. Distributed by Financial Media Exchange.