Bob French, CFA

What Happens After the Market Drops?

We’ve talked a lot about the importance of staying disciplined and the problems with market timing lately. Staying disciplined and avoiding market timing are two of the best investing tips we could give whether the market is up or down, but what happens after the market drops?

Last summer, when everyone was worried about China AND Greece, Dimensional Fund Advisors looked into what happens after the market has a sharp drop. The results are quite interesting. In short, the market rebounds pretty quickly and the higher returns persist long after the initial drop.

To figure this out, they looked for periods that met two criteria:

  1. consecutive days of negative index returns, and
  2. cumulative losses of greater than or equal to 5% or 10%.

Surprisingly, our current financial upset doesn’t meet the requirements for inclusion (knock on wood). Everyone is acting like the sky is falling, but we haven’t had any periods this month that would have made the cut for this analysis. The worst period this month was from January 6-8, when the S&P 500 Index dropped 4.7%. We came close, but keep in mind that 262 periods dropped more than 5%, not to mention the ones that didn’t make the cut but were still worse than 4.7%.

As you can see, the markets rebounded after a sharp drop and wound up outperforming their long-term annualized returns (by quite a bit) over the subsequent one-, three-, and five-year periods. The worse the hit, the better the markets did afterwards.

This goes to show just why you want to stay disciplined when the markets turn against you – if you are focused on the long term, you can harvest market returns.

If you tried to time this in an effort to avoid the bad days and only experience the good days, even if you got out while the market was going down, you would still have to know when to get back in. A large part of the “extra” returns above their long-term averages came quickly after the market dropped. If you miss a couple days, you might very well have missed out on all of those “extra” returns.

When you miss out on the good days in the market, you don’t get a time machine. They’re gone. If you can’t avoid the bad days, you might as well get the benefit of the good days.

Staying in your seat is the only way you can reliably harvest long-term market returns that will help you meet your financial goals.

We realize the current market volatility may have you concerned about your long-term plan. Let us help make sure you are on the right track.

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