Sensible Perspectives

August 4, 2011 Market Decline

Posted by on August 5, 2011

Yesterday, world stock markets declined significantly. The S&P 500 lost 60 points, or nearly 5%. Other US stock indices had similar losses. International markets had mostly smaller declines (3-4% in Europe, 0-2% in Asia). Today, Asian and European stock markets lost roughly enough to make up the difference with yesterday’s US market declines (although European markets have recovered somewhat since the announcement of US payroll growth this morning).

I do not recommend that you change your investment posture in response to yesterday’s market decline. However, if the decline made you uncomfortable, you may wish to review your allocation to stocks in light of your risk capacity and risk tolerance as I discuss below.

Stock investors appear to have two primary concerns:

Stock investors’ concerns extend into the future: the VIX, or S&P volatility index, rose to 31.7 yesterday. (This morning, it dropped to around 28 before rising back above 31.) The VIX (sometimes known as the “fear index”) measures investor expectations of market volatility. It is based on S&P 500 option prices – when it is high, investors expect large fluctuations in the stock market. These fluctuations can be down – or up. You may remember that I consider 10-20 to be the normal range, and 20-30 to be “normally abnormal.” In my view, the current reading is elevated, and at minimum, bears watching. If the VIX stays above 30 for an extended period, I will recommend against selling bonds to buy stocks when rebalancing. (Usually, if the stock market has declined during a quarter, rebalancing would involve sale of some bond holdings to purchase more stocks.)

Much of the stock market decline and increase in the VIX happened after the Congress approved an increase in the US debt ceiling. While interpretation is always conjectural at best, my interpretation is:

So, should you do anything about all of this? Should you adjust your investments?

Right now, the risks of investing, especially investing in stocks, appear to be larger than usual. In more normal times, the risks of investing in stocks appear to be small. But investing in stocks is always risky.

Professional investors’ inability to time the stock markets (to buy low and sell high) testifies to the difficulty of identifying the times that truly are more risky. Sensible Financial® believes that attempting to time the market is a losing strategy — people tend to sell at market bottoms due to panic, and to buy at market tops due to overconfidence.

Because the market is unpredictable, Sensible Financial focuses on your risk capacity in our discussions with you about your portfolio and your stock holdings. We want you to be sure that your plan will succeed even if your portfolio suffers the losses that the stock market sometimes inflicts. (This is why we are cautious about selling bonds to buy stocks in times of abnormally high market volatility — reducing your bond holdings at such times may place your plan at risk).

[For example, if you have $100,000 invested in stocks, a 50% stock market decline would result in a $50,000 loss. If you are saving $25,000 per year, you could make up the loss with 2 years of savings. If you are willing and able to work 2 extra years before retiring, you have the capacity to absorb this potential loss, and therefore the capacity to have $100,000 in stocks. On the other hand, if you are saving $5,000 per year, the loss represents 10 years of savings. If you are unwilling to work an extra 10 years to make up the loss, you don’t have the capacity to have $100,000 in stocks.

We distinguish risk capacity from risk tolerance. Even if you have the capacity to hold $100,000 in stocks, you may not be able to sleep at night with that much risk (you can’t tolerate that risk). Alternatively, even though you may be able to tolerate the risk, we will recommend against taking it if you don’t have the capacity to absorb it.]

In short, I do not recommend that you adjust your portfolio strategy either in response to recent events or in anticipation of events that may occur. However, if you are concerned that your plan may not be robust to potential losses in your stock holdings, please contact us immediately to change your investment policy as expressed in your Investment Policy Statement. Rick Fine, Jessica Plattner and Melissa Einberg are all in the office today. They will be able to help you. If you need to speak with me, one of them or Diane Shea, our Office Assistant, will be able to reach me.