In recent months, the market has experienced more volatility than it has in years. Though underlying fundamentals remain relatively strong, market setbacks can be worrisome. It is important to remember that short-term declines and corrections are a natural part of the investment process and should be expected as part of a long-term plan.
Let me help you put some of this into perspective. If we look back at the Dow Jones Industrial Average (an unmanaged index), beginning in the year 1900 and following it through to December of 2007, we learn the following:
A Routine decline (-5% or more) occurs on average three times a year and will last on average 47 days. A Moderate decline (-10% or more) occurs on average once a year and will last an average of 113 days. A Severe decline (-15% or more) occurs on average once every 2 years and lasts for 216 days. Our last Severe decline began in October of 2002, which then developed into a Bear market (-20% or more) which occurs on average once every 3.5 years and lasts 332 days.
These stock market cycles often cause investors to do the wrong thing at the wrong time. Historically, during periods when equity returns have been relatively high, investors flock to the market. When equity returns have been low, many investors have left… at a time when stock values have been most attractive.
In an effort to minimize loss and maximize gain many investors try to "time the market." If we look back at the S&P 500 over the last 10 years (12/31/97 to 12/31/07) we learn that the average annual return was 4.23% (not real exciting). However, if you had missed the best 10 days in the market during that 10 year period you would have lost nearly 5% of your original investment … ouch!
Many investors are aware of the market’s historical cycles, however, a Severe decline or Bear market can create an internal war between emotions and knowledge. As long as investments are made on the foundation of proven investment principles, it is simply a matter of weathering the storm. Unfortunately many investors do not understand the fundamentals of investing, and market declines prove to be the refining fire that reveals their weakness.
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