What I am about to write will probably not be terribly popular in this equity-centric culture of ours, but it needs to be said. On a number of business news shows over the weekend, I've heard about this past week's "equity market debacle." Fox Business News on Saturday noted that "retirees depending on their savings are very nervous right now" because of "serious damage to portfolios after the big sell off this week."
Get a grip, people!
To be sure, the 3% decline this week is the largest 5-day decline since June, but the real implication of that fact is that we have been in a frighteningly one-way market for a while now. I recently documented that we hadn't had a drawdown of more than 5% from a previous peak since June 24th, and nothing more than 2% for a couple of months. However, 3% declines over 5 days should not be unusual. If implied volatility, e.g. the VIX, is at 13%, which it was until this sell-off began, then a 5-day decline of 3% is only a 1.67-standard deviation event and it should happen about three or four times a year. The 2-day sell-off of nearly 3% was a more unusual event, but hardly financial Armageddon.
Here's the bigger point. You've laid out all your plans for the remainder of your life. If, one week ago, you were going to achieve your goals, but today with stocks 3% below all-time highs you are not, then you should not be in stocks. You're 3% away from success - why would you risk that?
If, on the other hand, you've laid out your plans but you need stocks to rise 30% per year to make your plans work - your retirement goals, or your kids' college education, or whatever - then you shouldn't be in equities either. The problem here isn't the market - it's your plans. I blame financial television for this one, for the popularizing of the absurd term "putting your money to work." Your money doesn't work. Money is inert. The best you can hope for if you prod it with a stick is that it doesn't blow away. Sometimes stocks go up, and sometimes they go down. From these valuation levels, it has long been the case that down was more likely than up over the next few years. Your money is "at work," but it's working in a wind tunnel and it's not tied down.
Stocks are risky assets, folks! A gambling metaphor is probably inappropriate, and investing is different from gambling in that with gambling, the gambler generally loses over time while with investing - smart, patient investing - the investor generally wins, but here is one way in which the metaphor works: when you enter a casino, you only gamble what you can afford to lose. In the case of stocks, you should only invest as much as you can afford to lose 60-70% of. So your first question, in thinking about your asset allocation, should not be "how much do I need my portfolio to return," and then spin the risk dial so you get the answer, but "can I lose 70% of this and still accomplish my goals?" If the answer is no, then you are risking too much because stocks sometimes do fall 70%.
And if you can't accomplish your goals with the cash you have unless you have a strong equity market, then you have two prudent choices: 1) work harder, and longer, or 2) save more during the same period of work. The third choice is to gamble it on stocks and hope it turns out well.
If you're over-committed to equities, this is an excellent time to reconsider that commitment. If you have ridden stocks up, then pat yourself on the back and think hard about reallocating. You haven't lost much and it shouldn't be keeping you up at night…because the 'carnage' just isn't that bad. The chart below (source: Bloomberg with my annotations) is of the ETF EEM, which tracks the MSCI Emerging Markets Index. Repeatedly on Thursday and Friday, we heard that U.S. stocks were suffering because of the "rout" in emerging markets. Some currencies took a hit, yes. But emerging equity markets were hardly "routed." Again: if 12% is going to destroy you financially, then you should count on being destroyed with some regularity.
I have to say the carnage isn't that bad yet, because stocks might still drop precipitously and in any event probably won't perform like they did for the last six months again for some while. But if you have the right, prudent plan, then not only do you not have to panic now, you won't have to panic then.