Whatever triggered that mysterious thousand-point stock market tumble on May 6 — a "flash crash" that briefly vaporized some $1 trillion — it served one good purpose: After 13 months of remarkably steady gains, we were all reminded that the market is inherently volatile. Though stocks tend to beat other investments over decades, seldom do they move smoothly upward for long. The stock market is, by nature, a roller coaster.
And really, how could it be otherwise? The market measures our collective greed and fear, and the persistent worry lately is that, despite some promising signs, the worst global economic downturn since the Great Depression isn't over — that we may be headed for a second trough.
This doesn't mean you should abandon stocks. On the contrary, you need their higher long-term returns to build your retirement savings. You just have to learn how to ride out the losses. Remembering these five market truths will help.
1. The market knows much less than you think
Stock prices aren't a mirror held up to the present. The market reflects investors' guesswork about what might happen tomorrow, next week, or six months from now. The disconnect between the two became particularly clear when the economy tanked. In 2009 we were deep in a recession that cost more than 8 million people their jobs, and housing prices had taken their biggest dive since the 1930s. Yet from its low in March 2009 to its high in April 2010, the S&P 500 Index rose an astounding 80 percent — a speculative bull market fueled largely by the Federal Reserve's near-zero interest rates. This is why trying to buy stocks at the bottom and sell them at the top is so hard. Sometimes stocks command more than they're worth, sometimes less. Your best strategy is called dollar-cost averaging: Invest the same amount regularly so you get fewer shares when prices are high and more when they are low.
2. Professional traders are short sighted
In May a crop of genuinely upbeat economic news — a little more hiring, stabilizing home prices, rising consumer confidence — offered signs of a nascent recovery. At the same time the stock market plummeted. The S&P 500 Index lost 10.5 percent — its biggest one-month drop in decades. The nosedive was a nervous reaction by institutional traders to bad news from Europe — especially the fear that Greece would default on its debts, triggering a new chapter in the financial crisis … and perhaps the recession's second dip.
Stoking the panic was German chancellor Angela Merkel’s reluctance to embrace a European Union bailout for Greece. She was concerned about a regional election and didn't want to alienate German voters. By hanging tough, she helped drive up lending rates in Europe, which frightened the U.S. stock market. Then Merkel agreed to a bailout, and the stock slide abated along with immediate fears for Greece — proving once again that investing based on the market's gyrations is a recipe for emotional and financial whiplash.
3. Keep your focus on the big picture
Disturbing headlines are inevitable: Home foreclosures are expected to continue at near-record rates; many states face ugly choices between slashing budgets and raising revenue; the BP oil spill may hobble the Southeast. Yet in May, even as the European crisis unfolded and the market fell, a panel of 46 leading economists predicted the U.S. economy will grow a solid 3.2 percent both this year and next. "We're climbing out of a deep hole, but our problems are much less severe than a year ago," says Mark Zandi, chief economist at Moody's Analytics. "Businesses in the U.S. are very profitable, and we’re seeing some job growth, increasingly broad-based across industries and regions of the country."
4. Besides, bad news often has a flip side
In economics there are always both winners and losers. With European debt looking risky, demand for U.S. Treasuries shot up — which lowered rates on mortgages here. Homeowners who refinanced will have more cash to spend, boosting economic growth. Oil prices fell as Europeans, hunkering down, drove less, making it cheaper for us to drive. And a falling euro has strengthened the dollar — making imports cheaper for Americans.
Even the market's slump in May has a silver lining for investors looking decades ahead. (Yes, that includes you. People in their 50s or 60s may need their money to grow for 40 years.) If you're adding steadily to your invested savings for retirement, you're now buying stocks at lower prices. That greatly enhances your potential long-term return: The less you pay for stock investments, the more you're likely to make when you sell them. That's why experienced money managers aren't sorry to see market "corrections" that keep stock prices in line with reality.
5. The basics of finance still apply
Consult a financial professional to see how these strategies might help you.
Diversify: You need a broad mix of stocks, bonds and cash.
Protect your future cash flow: Put money you'll need to spend within five years in a money market fund.
Stay flexible: Don't tie up all your money in supposedly crash-proof gold or a deferred annuity.
Slash your investment expenses: You can own a diversified portfolio at minimum cost with three low-cost index funds: total U.S. stock market, total foreign stock market, and total U.S. bond market.
Save more: If your portfolio isn't growing fast enough, there's no magic to apply. Set aside more income.
Remember your time line: Your true investment horizon is your life expectancy, not your retirement date. If you have a prudent plan, and can stick to it, you won't lose sleep over the market's inevitable ups and downs.
Contributing editor Lynn Brenner made the case for banking at a credit union in the July–August issue.