Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.
Stock markets are finally reminding investors about the risk side of the risk-reward equation, with the Dow Jones Industrials (DJINDICES:^DJI) responding to turbulent conditions among emerging-market economies by ignoring positive earnings news and plunging 186 points as of 12:30 p.m. EST. Predictably, a second straight day of triple-digit declines has some already trumpeting a "correction" in stocks. But before you declare the bull market over, it's important to realize that we haven't even come close to what most people used to consider a correction.
Even taking today's declines into account, the Dow is down just 3.4% from its record level set on New Year's Eve. The S&P 500 (SNPINDEX:^GSPC) has had an even smaller fall, to a level just 2.4% below the record it set just nine days ago. Nearly three-quarters of the Dow's 30 components are within 10% of their yearly highs, and fully half a dozen stocks in the blue-chip index are within 5% of their record highs -- Boeing (NYSE:BA), Visa (NYSE:V), Disney, Home Depot , United Technologies, and Johnson & Johnson. Moreover, in the context of Boeing's 91% gain in the past year, a mere 5% drop is hardly worthy of notice.
The reason why so many investors are near panic is that they're not used to seeing any choppiness in the markets. In terms of market volatility, 2013 was extremely unusual, with rock-bottom levels in the S&P Volatility Index (VOLATILITYINDICES:^VIX) lasting pretty much throughout the year. Even though the Dow has soared from below 7,000 less than five years ago to more than 16,000 today, investors still have the mindset that triple-digit daily moves are extraordinary. Last year, the Dow moved 1% or more in either direction just 23 times out of 250 sessions, and on only two occasions did 1% moves come back-to-back. Nor has this year been drastically different -- even if Dow drops more than 1% at the close today, it would still mark just the third 1% move for the average since Jan. 1 despite the perception of higher volatility in 2014.
As you assess your risk tolerance, it's important to stay aware of some simple facts:
- Even for just a 5% correction -- something you'd expect to happen three times a year on average -- the Dow would still have to drop another 275 points from here.
- A 10% correction -- which usually happens roughly annually -- would involve the Dow dropping 1,100 points from current levels.
- If a true bear market hits -- usually defined as a 20% drop and occurring about once every three or four years -- then it would mean the Dow would have to fall about 2,750 points.
In short, if you think what we've seen so far in 2014 is a correction, then you don't remember what a real correction looks like. That doesn't mean you should panic, but it does mean you need to remind yourself of how markets typically behave before making decisions about how much risk you're willing to take on.