The equity markets are off to a shaky start in 2014 after the smooth upward climb for the U.S. equity indexes in 2013. Currently, the Dow, Nasdaq, and S&P 500 are negative so far this year, while other asset classes, such as bonds, have moved higher.
Since 1928, the S&P 500 normally experiences a five-percent correction three or four times every 12 months. A decline of ten percent is more rare, but still seen once each rolling 12-month period. A bear market, down 20% or more, is seen once every three or four years. These are averages, and any one year can deviate from the norm, as we saw in 2013.
The question many investors and retirees ask is what, if anything, can (or should) they do about the normal levels of volatility we see in the equity markets? The answer to this question all depends on risk tolerance. One of the definitions Meriam-Webster’s dictionary gives of “tolerance” is the ability to accept, experience, or survive something harmful or unpleasant. If an investor panics and sells after every 5 to 10% decline in the market, equities are probably not for them. If the average market volatility (2nd paragraph above) can be tolerated, then having equities in your asset allocation plan is prudent as long as it aligns with your desired level of risk. In a year like 2013, such a plan might have seemed useless as we saw the U.S. equity indexes outpace pretty much everything. However, and this is important, you should not develop an asset allocation plan based on an outlier year. If you did, then you would have held zero equities after 2008 and 100% equities after 2013.
Sticking with a diverse and properly allocated investment plan could lower the overall volatility and increase comfort during normal, and inevitable, stock market corrections. To ensure your comfort level (sleep tolerance as Windsor calls it) remains steady, consistently rebalancing to maintain proper allocation is critical. Certainly after corrections or abnormally large market gains, bringing your asset allocation back in line with your desired level of risk is a proactive response. This is in stark contrast to the extreme reactive response by many retail investors who get out of the market after it goes down and jump back in to equities after markets have gone higher.
We understand these strategies are hard to implement since you are going against the tide of recent performance. However, risk-based asset allocation and rebalancing are time-tested and proven ways to increase your comfort level and help you avoid mistakes that many investors make.