Q: I’ve been planning to invest a large amount of money in a Vanguard index fund. Just when I was ready to fill out the forms the Dow Jones industrial average started to fall and alarming news stories were calling it a correction. I don’t want to put money into this fund and immediately lose it. Can you explain correction and what I should do about it? Is this temporary? How will I know when it’s over?
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A: The term “correction,” is one of three words that investing professionals use to help people understand just how scary, or damaging, a stock market plunge might be for the stocks and stock mutual funds that people hold.
The stock market terms are a little like the categories used to warn people about the severity of an approaching hurricane. While a Category 1 hurricane might be a pain, it is usually nothing to fear. It will blow over quickly and be easy to forget even if you’ve had some household damage to repair. A Category 5 will be devastating, with destruction that will last months or years.
The stock market’s three categories for losing money are pullback, correction and bear market.
A pullback is mild. It might make you nervous as the damage is being inflicted to your money, but it will blow over quickly. You might lose 5 to 9 percent of your money, but the losses will heal quickly. Within a few weeks you might not even remember that it happened. By the end of the year if you look over your 401(k) or IRA, the short-term losses on your money probably will be indiscernible.
That’s true of a correction too, although when you are in the midst of one, it will be scarier and you will wonder if it will become more destructive for your money. In a correction, you temporarily lose 10 to 20 percent of your money, maybe over a couple of months. But on average you are back to even in four months, according to Standard & Poor’s research.
The trouble with a correction, however, is that you never know exactly when it will be over, and a correction can morph into a bear market. The stock market storm to fear is called a bear market. It causes tremendous damage and lasts a long time. In the case of the 2007-09 bear market, stock market investors lost about 55 percent of their money and didn’t recover what they’d lost for about five years.
Keep in mind that even in that horrific period, investors did recover, and between the worst point of 2009 and the recent past, investors enjoyed tremendous gains of more than 150 percent on money that remained invested.
Most bear markets aren’t nearly as bad as the one from 2007 to 2009. According to research by the Leuthold Group, investors lose about 38 percent in the average bear market. The median time to return to even is two years and three months. And over years of investing, the person who sticks it out ends up fine even though bear markets show up on average about every four years.
The thought of having to go through corrections and bear markets sometimes makes people think they should simply skip the stock market. But history has a way of papering over the distress. The stock market climbs much more than it falls, because it’s a reflection of the U.S. economy, which tends to mostly move forward despite some recessions.
So if you go back to 1929 and calculate how a person invested in the stock market would have done if they’d enjoyed the good times and lasted out the bear markets, corrections and pullbacks, they would have earned on average about 10 percent a year.
As a result, financial advisers typically tell people to keep all money out of the stock market if they will need to spend it within five years. But if they have the protection of cash and bonds, they don’t need to flee stocks or stock mutual funds during a correction. Consider the person with $10,000 invested — half in the stock market and half in Treasury bonds — during the horrible bear market of 2007-09. By the ugliest period in 2009, only $7,780 of the original $10,000 would have remained. But as the healing took place, the money grew. By March 2012, they would have had about $12,945.
Since guessing exactly when that healing will take place is impossible for even the savviest analysts, financial advisers typically tell people with a large chunk of money to invest in a downturn to take their time. They won’t know when the correction will be over. But if the person does dollar-cost averaging — or putting a portion of the money into a stock fund every week or month for an extended time — they will ease the bite if the correction continues. If the stock market declines, each week the allocation of dollar-cost average money will buy more stock for less money. If the stock market ends its correction and starts climbing, the investor’s money will be in the mutual fund, set up to make gains.
“Everyone tries to time the market and it’s very hard to do,” says John Kosar, research director at Asbury Research. “Keep some powder dry,” investing a little at a time.
Twitter @gailmarksjarvis