After another good year on Wall Street in 2014, some stock market prognosticators are predicting a reversal of fortunes for 2015, while others expect another good year for investors. However, no one really knows what will happen next, and the best thing you can do is to plan for all possibilities. You also can learn from stock market history, while recognizing that past performance is not a guarantee of future results.
These days we keep hearing word that the Fed is going to raise interest rates and the market will respond with a temporary pull-back. The timing of rising interest rates is a topic up for discussion weekly that causes the market to sway back and forth, hanging on indicative words like “patient” by Fed Chairman Janet Yellen. Then there’s the other school of thought that market valuations are too high and a pullback of sorts is in order. However, such talk was said at after each new market high in 2013 and 2014. Nevertheless, the market kept marching upwards, making the bears sound like Debbie-downers and convincing sidelined investors to re-enter the market and chase returns at dangerous market highs.
The stock market is known as a leading economic indicator — that is, it tends to rise or fall in advance of economic gains or losses. That’s what happened when the most recent bear market bottomed out in March 2009. Finally, several months later, the U.S. economy, too, moved into positive territory, although the recovery has been painfully slow by historical standards. During most bull markets, the economy is strong and unemployment low. Consumers feel relatively confident, and their outlays help fuel economic growth. Additionally, because times are good, people usually are more than willing to take the risk of owning stocks.
Conversely, worries about the economy may make investors sell their stocks, and that drop in demand can lead to a bear market. Usually, prices will begin rising again after a fall of 40% or so. However, in a particularly bad bear market, such as during the Great Depression, that percentage drop can be significantly greater before things turn around. In such a situation, as the economy sputters and unemployment rises, investors shy away from taking risks in the market.
Some investors try to gauge what market sector is going to do well and move assets there ahead of everyone else to get in early and capture growth. However, it’s easy to be wrong or “buy high” after everyone has already realized this is the hot market sector and pumped up the prices.
Conversely, in a bear market, some investors consider tactics like “selling short” — borrowing stock you don’t own, selling it, and waiting for the price to drop. Then if you’re able to buy back the stock at a lower price, you’ll profit. However, this is a lot like betting in Vegas. You could be right and turn a pretty penny, but there’s a 50-50 chance you’re wrong and you end up buying to stock higher than you anticipated to pay back a loan at twice the cost. Market timing is hard because greed can make you hold out longer for your profit margin to grow larger. But if you’re too greedy, you end up trying to reduce your losses rather than maximize your profit.
The best strategy to use in any market is to diversify your portfolio of investments so that in a good market, you are capturing market growth in measured way, and in a declining market, you have assets that protect you on the downside to offset equity volatility. Modern Portfolio Theory has been a tried and true strategy that builds on this philosophy of balancing asset classes. Under this approach, if small US companies have a good month, you have some money invested in that asset class so you benefit. If the US economy is slow but the international market takes off, you’re happy too because you have a proportionate share of money invested in that international funds too. This strategy is the opposite of putting all your eggs in one basket. You can avoid the volatility of holding just one stock or one sector of the market and that helps many investors sleep better at night.
A Certified Financial Planner or investment advisor can guide you on how to implement a strategy of diversification for you. Each portfolio should be tailored to your risk tolerance and personal financial goals to help you be the most successful. For example, a person who is saving for retirement in 30 years can take a lot more risk than a person who plans to retire in 5 years. Your portfolio should recommend who you are and where you’re going.
The main thing to learn from stock market history is that you have a better chance of succeeding by maintaining a long-term approach. Over time, the stock market bounces back from bear markets, and it’s advisable to not buy or sell stock just because the market is bullish or bearish. Being informed and methodical will serve you better than selling stocks in a panic or trying to jump on a bandwagon.