The stock market has taken investors on a rollercoaster ride over the past few weeks, jangling plenty of nerves in the process.
In times like these, looking at some historical perspective can go a long way toward easing investors' minds. Specifically, let's look at market corrections, which are said to occur when the market falls 10% from a recent high point.
Market declines of 10% occur, on average, once per year, according to research by JP Morgan Asset Management. And drawdowns of 20% take place once per market cycle.
The bottom line is that corrections are completely normal. They're part of the process that, over time, keeps the prices of stocks in line with their fundamental value based on earnings and other factors. You might think of corrections as a pressure valve, keeping the market from expanding into a dangerous bubble.
Market corrections are definitely a concern for short-term traders: You can hear them obsessing about the market's daily moves—or even hourly moves—on cable television.
But for those investing to achieve a long-term goal such as a comfortable retirement, all of this is just sound and fury, signifying very little. Such investors should be relying on diversified, long-term portfolios that are designed to withstand the market's short-term dips and curves.
Yes, the value of such portfolios will typically fall during corrections. But over a period of many years, they will do a better job of protecting your capital and safely growing it than is typically possible through short-term investing.
In fact, the biggest risk to investors during corrections is their own behavior. As we discussed in "Behavioral Biases: What Makes Your Brain Trick?" humans are wired to make poor decisions during times of stress.
When markets are falling, our natural inclination is to get out—even though that means turning paper losses into real losses. Indeed, impulsive investor behavior helps to account for a well-documented "behavior gap," that is, a gap between market returns and individual portfolio returns.
Research firm Dalbar has found that a lack of discipline contributes to a significant gap between the average investor's return and the return of the S&P 500 stock index. Over the past 20 years, the S&P returned 9.22% annually, while the average investor's return was just 5.02%
We can't predict the markets' behavior over the short term. Stocks may continue to fall further, or they may stabilize and push forward. But we do know that our capitalist economy, which underlies the markets and ultimately is responsible for wealth creation—is alive and well.
Free-market capitalism will survive the latest correction, just as it survived everything from the 2007-2009 "Great Recession" to the Great Depression nearly a century ago. Like the stock market, the economy will rise and fall. But historically, it has expanded over the long term and promises to do so going forward. As the economy expands, the stock market will rise.
Rollercoaster rides can be scary. But those who keep their heads, and stick with their long-term investing plan, will be able to harness the power of the free market to achieve the growth they need to reach their goals.