Don't Panic: Stock Market Crises Are Normal

Last Updated Aug 5, 2011 10:42 AM EDT

We are once again faced with extreme turmoil in markets, with the Dow dropping 513 points on Thursday and 12 percent in the last week-and-a-half. As I have pointed out many times in the past, crises happen with far greater frequency than most investors believe or remember. In other words, crises are normal. It has long been known that equity returns are not normally distributed, that they exhibit "fat tails," meaning they experience far more large gains and large losses than would be expected under a normal distribution.

In fact, the frequency of such turbulent times (and the severe bear markets that can result) is responsible for the high equity risk premium investors demand. And that risk premium goes up sharply in times of turbulence. In other words, bear markets are when you earn the greatest returns (for taking risk when others are no longer will to do so); it's just that you don't know it at the time. As a recent reminder, from May 3, 2010 to July 2, 2010, the S&P 500 Index fell almost 15 percent. By the end of the following April, it had risen more than 33 percent. In other words, the key to success is to have a plan that anticipates bear markets and then have the discipline to stay the course. There are several main points I would like to make.

First, since this crisis is financially driven, there's the potential for markets to once again "seize up" as they did during the Lehman crisis. Thus, you should at least consider increasing your amount of liquid assets. For example, if you normally maintain a three-month reserve for emergency needs, you might consider increasing that to six months.

Second, it's important to remember that during crises the correlations of risky assets tend to rise to one, meaning when one tends to underperform its historical average, so does the other. Thus, it's critical to make sure your portfolio has a sufficient amount dedicated to the highest quality fixed income assets, enough to dampen the portfolio's risk to an acceptable level. If that isn't the case, you should consider taking action. I would also recommend that you consider tightening credit standards, especially if you're invested in corporate bonds or in municipal bonds with lower than an AA rating.

Third, because there's no guarantee that this crisis will be resolved favorably in the near (or even long) term, you should review your investment plan to determine if you're taking more risk than you have the ability, willingness or need to take. The bull market of the past two years may have allowed you to lower your equity allocation. Running a Monte Carlo simulation can help you determine if you can lower the risk profile of your portfolio.

Finally, I do believe that the world is a riskier place now because of the damage done to the global financial system by the 2008 crisis. Obviously, the markets agree. One way to address the heightened risk is to lower your overall exposure to equities, while at the same time increasing your holdings of small-cap and value stocks. Done correctly, that would allow you to keep the expected return of the portfolio the same, while cutting the tail risks.

There's a tremendous amount of uncertainty in the markets as well as the world. Making sure your portfolio is appropriately tailored to address these concerns is your best safeguard. Tomorrow, we'll discuss why the markets have reacted this way, why there's so much uncertainty, and how you can maintain a balanced perspective.

Photo courtesy of Katrina.Tuliao on Flickr.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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