This is a guest article by Rob Bennett, a personal finance journalist and author of the blog A Rich Life. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s.
You naturally get worried when you see the value of your retirement account drop. Most experts say that you should ignore the ups and downs of the market. But that’s hard. We all want to be sure that we are on track to meet our retirement goals.
The purpose of this article is to offer more detailed and more balanced advice that what is usually put forward by the experts. It is true that there are some circumstances in which it really is best to tune out the market noise. However, recent academic research shows that there are other times when stock price drops should be a serious concern.
There are six sorts of stock price changes you will experience and letting you know the proper way to react, given how stocks have always performed in similar circumstances in the past.
Situation one: Losses incurred at a time when stocks are selling at fair value prices
Say that stocks are priced at fair value (that’s a P/E10 value of 15). Should stock price drops be a concern?
No, not at all. Losses experienced from price drops starting from fair-value prices are always recovered over the next 10 years or so. So these are strictly temporary setbacks.
In these circumstances, the experts are absolutely right. The worst thing to do following a price drop starting from fair-value prices is to sell your stocks. That turns those temporary losses into permanent losses. You want to hold the stocks until the losses are recovered.
Situation two: Gains incurred at a time when stocks are selling at fair value prices
What if you instead see gains starting from a time when stocks are selling at fair-value prices? Are the gains temporary too?
U.S. companies generate enough productivity to support annual gains for the broad stock indexes of 6.5 percent real. So the market price is constantly moving upward. So long as your gains are not more than 6.5 percent real, those gains are not temporary but are yours to keep.
Even if the gains are more than 6.5 percent per year, there probably is not much cause for concern. The average 6.5 percent return for U.S. stocks is good enough that price changes that lower that number a bit for the future don’t cause serious problems for investors. So what if your returns in future years will be only 5 percent real or only 4 percent real? That’s still better than the return you could earn in alternative asset classes. You still want to keep your money in stocks.
Situation three: Losses incurred at a time when stocks are selling at super-low prices
These are the times when you want to be certain to be heavily invested in stocks. You can’t lose. Once prices are already low, they can’t go any lower. If prices remain at the same valuation level, you will obtain that average 6.5 percent return. If they move up to fair-value price levels (they always do in the long term), you will see a return far better than that.
There’s only one problem. Prices only go to super-low levels when most people are so scared about their financial futures that they are not willing to pay a fair price for stocks. You will be hearing lots of stories in the media at such times that the entire economy is about to collapse. You want to try to tune that stuff out.
If the economy really does collapse, there is no good investment class. So you wouldn’t be losing anything by being in stocks, If the economy recovers, those in stocks will generate more wealth in 10 years than they could in 20 years of investing at other sorts of time-periods. Do not get caught up in the gloom and doom!
Situation four: Gains incurred at a time when stocks are selling at super-low prices.
All gains incurred at times of super-low prices are yours to keep, even gains far above the 6.5 percent average return figure. This remains true until stocks are again selling at fair-value prices. So enjoy the ride up! You earned it by managing to tune out the gloom and doom message threatening to throw you off the horse.
Situation five: Losses incurred at a time when stocks are selling at super-high prices.
This is the circumstance in which I disagree with the advice offered by most experts in this field. Losses suffered starting from super-high prices are never recovered. When you pay more than a fair price for stocks, a portion of your money is going to the purchase of stocks and a portion is going to the purchase of cotton-candy nothingness. Prices always return to fair value. So these price drops are not so much losses as they are the market coming to recognize phony gains experienced at an earlier time for what they really are.
Situation six: Gains incurred at a time when stocks are selling at super-high prices.
Stocks are dangerous when they are selling at super-high prices. Gains experienced at such times just make the stocks you are holding that much more dangerous to hold. Investors going with high stocks allocations in such circumstances are living on borrowed time.
Published or updated March 15, 2012.