When (and if) it finally happens, you won’t be able to say you weren’t warned. The media has certainly been warning you. There isn’t a day that goes by that I don’t see a headline from a newspaper, a television show, or some website about the upcoming crash, correction, or bursting bubble that is coming soon in the stock market.
I can’t say that I disagree that we are due for some kind of pullback. We’ve enjoyed an eight-year bull market since the financial crisis of 2007–2009. All three of the major stock market indexes are at record highs. In fact, the current rally, at 98 months long, is the second-longest bull run since World War II. While it hasn’t been a straight run to the upside, it has been a steady upward trend since the market lows hit in March 2009.
But in the short run, since the election of Donald Trump as President of the United States, it’s been mostly a straight move higher for stocks. On Election Day last year, the Dow Jones Industrial Average, which is the most widely used measuring stick of the overall market, closed at 18,332. As I write this post, the Dow is at 21,384. That’s a gain of 3,052, or 16.6%, in seven months. Whenever we see the price of anything run up that far and that fast, we expect the price to eventually pull back a bit. Trying to predict when and how it’s going to happen is when we get into trouble.
The fact that the markets have moved higher since the election hasn’t been surprising. After all, President Trump was viewed as more pro-business than President Obama. If things are going well for businesses, profits increase, and that usually means higher stock prices. So a rally after the election wasn’t all that surprising. What has been surprising is the magnitude and velocity of the rally.
It’s especially surprising when we look at the economic reports. We seem to be in a period of slow economic growth and low productivity growth, and stocks are expensive based upon historical price-to-earnings measures. The main initiatives of the new administration—like tax reform, revamping our health insurance system, and reducing regulations—seem to be stuck in Washington’s gridlock. All things considered, it’s no wonder that the “experts” are calling for a reversal.
So, as investors, what should we be doing to protect ourselves?
The first thing we should do is review our risk tolerance. How much risk are you comfortable with? Keep in mind that most people have a higher tolerance for risk when the market is moving higher. It’s not that the tolerance for risk is actually higher—it’s that the markets seem less risky when they are moving higher. And the portfolio-damaging emotion of greed creeps in to make you think you are more risk tolerant that you really are.
We should also remember that it works the same way when stock prices are falling. When the headlines in the newspapers, on television, or on the internet are screaming about how much stocks have fallen, the other portfolio-damaging emotion—fear—creeps in, and suddenly you are not as risk tolerant as you thought. Many people learned this the hard way during the 2007–09 crisis.
You should also remember that you are about 10 years older now, and 10 years closer to the time when you will need your investment dollars. Most likely, the value of your portfolio is also substantially higher now, so you have more at risk.
Next, you should make sure that your portfolio is well-diversified by being spread across several asset classes. The Dow Jones Industrial Average and the S&P 500 are not representative of what your portfolio looks like. These indexes are made up of the stocks of large U.S. companies. A properly diversified portfolio will also include stocks of small and medium-sized companies, and a good helping of stocks from other countries. You should also hold a mix of bonds. The bond side of the portfolio should be spread across different maturities, governments, and corporations. The proper mix for you should be based on how you answer the risk tolerance question.
Remember that diversifying your portfolio will mean that you won’t enjoy the same returns as the “hot” asset class, like U.S. stocks right now. But it also means that when that hot asset class suddenly turns cold, you won’t suffer the same damage.
Finally, you need to stay disciplined. Whether things are going very well for a particular asset class, or very badly, you need to stick with your investment strategy. Don’t let the headlines, good or bad, affect the way you manage your portfolio.
OK, you’ve been warned. Sometime in the future, the markets will go down. We don’t know when, and we don’t know by how much. But whether you want to call it a crash, a correction, or a bubble bursting, now you know how to deal with it.