When stocks sell off, everybody wants to know why. Last week's sell-off is being blamed on everything from the collapse of the peso in Argentina, to a contraction in manufacturing in China, to disappointing Q4 earnings announcements in the U.S. Whatever the case, the bigger concern is how long the sell-off will last.
Of course, nobody knows for sure how long any sell-off will last. To keep things in context, keep in mind that stocks rallied about 30% last year. That's a rather large one-year return. Over the long term, stocks tend to rise by approximately 8-10% annually. But that is just the average-- average, of course, implies variation. For example, if stocks go up 10% every year for 10 years in a row, the average return is 10%; but in this case, there is no variation. This would be a highly unlikely occurrence. On the other hand, if stocks fall 5% every year for five years in a row and then rally 25% per year over the next five years, the (arithmetic) average annual gain is still 10%. This, too, would be a highly unlikely occurrence; however, in this case, there is variation. Notice also that in the second case, even though the average is 10%, there was no actual year in which stocks rallied 10%.
The point is that sell-offs are inevitable. As Warren Buffett has said, long-term investors should welcome sell-offs. It gives them the opportunity to buy more shares at lower prices. No one, however, can consistently pick the tops and bottoms. When you buy stocks following a sell-off, you run the risk of getting in too early.
The S&P 500 is down only about 3% since the year began. Many pundits have been calling for a 10% correction. Even long-term bulls view 10% pullbacks as healthy. We're still a ways from that point, so the selling could easily continue for a while. In 2013, the stock market rallied strongly even though the economy showed little signs of health. This year (so far), the economy is looking better. However, that does not imply further gains in stocks. To a large extent, last year's rally anticipated an improving economy.
Because so many factors (including Federal Reserve policy) can affect the mood on Wall Street, it is important for investors to focus on what they can control. One of the most important things they can do is to decide how much of their money to put at risk. This is commonly referred to as asset allocation. It may be more fun to decide which stocks to buy, but research shows that it is more important to decide how much money to put into stocks in the first place. For example, should you put 40% of your portfolio into stocks or should it be 80%? The answer depends on a number of factors; perhaps the most important of which is how much risk you can bear. In any case, once you set the target, you also need to rebalance your portfolio when it gets out of whack.
Let's say you started 2013 with a target allocation of 70% of your portfolio in an S&P 500 index fund and 30% in cash. You would have finished the year with about 75% in stocks and only 25% in cash. If you want to get back to your target, you would have to sell some of your index fund. Alternatively, when stocks fall, you would want to buy more of the index fund to bring your exposure back up to 70%.
How often you rebalance and by how much can depend on transaction costs and tax liabilities. When costs are low and taxes aren't an issue (e.g., in a tax-deferred account at an online brokerage firm) rebalancing can take place more often. When transaction costs and taxes are high, you would probably choose to rebalance less often.
Right now, we are in the heart of earnings season, so we can be sure to see more volatility in the days and weeks ahead. Furthermore, Ben Bernanke's last FOMC meeting as Chairman of the Federal Reserve occurs on Jan. 30. The Fed has embarked on a course of reducing the amount of quantitative easing. The market currently expects the Fed to announce an additional $10 billion reduction in easing. That means the Fed would continue buying bonds at the rate of $65 billion per month. One thing is for sure. If the Fed chooses some other course of action, stocks will respond very quickly one way or the other. In fact, if the past is any guide, stocks could shake, rattle, and roll even if the Fed does exactly what is expected.