Stock markets around the world have gone on a wild ride over the past week, sending a shiver up the spines of investors wondering how the turmoil might affect them. Growing concern over an economic slowdown in China was already slamming the commodities markets, depressing stock prices of global materials and energy producers. Then the bubble in Chinese stock markets burst, triggering a global selloff over the past week that reached near panic proportions on Monday. Tuesday's action was less frenetic and opened strong, but turned to losses in late trading.
Given the dramatic declines of the past week, how should a typical investor respond? By keeping the moves in perspective, sticking to a solid long-term plan, and tuning out the noise.
First, the perspective. After the carnage of Monday's action, the major U.S. stock markets all finished in so-called correction territory. According to a general (and quite arbitrary) classification, a correction is a decline of 10 to 19 percent from a previous high. Thanks to a 4 percent drop during the trading session, all the major U.S. averages met that criterion.
Because it has been so long since the last correction (summer of 2011), many investors forget just how common and important these brief pullbacks are. There have been 27 such downturns since the end of World War II, coming at an average frequency of about once every 1.5 years. Clearly this correction was long overdue.
Furthermore, markets never move straight up indefinitely, nor can they. Over long periods of growth, imbalances gradually multiply as investors chase pricier stocks and latecomers to the market jump in for fear of missing the boat. The term "correction" is itself evocative of the necessity to let off some steam, shake out the marginal participants, and position the market to resume a healthier pace of expansion.
Monday's action was admittedly disconcerting due to the magnitude of early losses. The Dow Jones Industrial average plummeted by nearly 1,100 points within minutes of the opening bell, and many equity ETFs were trading at comically low values relative to the stocks inside them. It was quickly evident that heavy computerized trading was the culprit, as more machines hit the "sell" button than the "buy" button. But by midday, balance had been restored thanks in part to the recently installed system of trading time-outs called by the exchanges. These "circuit breakers" tripped more than 1,200 times on stocks under heavy selling pressure during the day, halting trading for five minutes when certain downside limits were hit and allowing buyers to enter the market to restore balance. By the close, nearly half the losses had been recouped.
Tuesday's session was more orderly but took the market down another 1.3 percent.
Long-term investors for the most part appear to have stayed the course. It is just such a volatile period that highlights the essential need for a plan of action that provides the fortitude to weather intermittent storms. Given a sufficient time horizon, corrections may be embraced as a healthy mechanism for restoring equilibrium and clearing the decks for smother sailing ahead. It is all too easy to obsess over the abrupt 11 percent decline and forget the mammoth 200 percent gain since the market rally began in 2009.
Finally, a game plan allows one to tune out the noise. Financial reporting during the trading day took on an unhelpful aura of abject panic but provided little useful information for investors. Remaining focused on ultimate goals and sticking to the plan are the best ways to ignore the clamor and maintain discipline.
Remain calm and carry on.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.