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Notes From the Fieldby Martin Weil

July 22, 2014

A Correction Will Come – Are You Ready?

As I wrote in my July letter, it has been some three years since the stock market last had a normal correction, a decline of more than 10%. These can be nasty experiences for those who may have accustomed themselves once again to steady market gains. This seems a dirty trick but it is just the way of the market.

A recent study, explored in Jason Zweig’s Intelligent Investor column in the WSJ, finds that individuals become risk-averse very quickly when exposed to the sorts of stresses provoked by sudden market declines. After such rapid sell-offs, markets typically recover gradually, but investors remain fearful of further losses and unwilling to take that risk for the prospect of seemingly small gains.

Exposure to stress makes people more loss-averse and diminishes their overall sensitivity to reward. and if a reward is of low magnitude, [people under stress] often don’t care about it very much.

Mauricio Delgado, a neuroscientist in the psychology department at Rutgers University in Newark, N.J.

There is no way to know whether the next market correction will come next week, next month or next year. But if there is anything that is certain, it is that there is one in our future. Which is why I am stressing that investors “fasten their seat belts,” by which I mean making sure that their portfolios are positioned so that the investor can psychologically (and financially) endure a 15% or greater stock market sell-off without panicking into selling.

 

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