Well, that was ugly.
Wall Street and investors typically look to the first couple of weeks of trading in January to set the tone for the remainder of the year. This past week for the Dow Jones Industrial Average (^DJI -0.59%), Nasdaq Composite (^IXIC), and S&P 500 (^GSPC -0.20%) was nothing short of ugly. The S&P 500, Dow Jones, and Nasdaq lost 6%, 6.2%, and 7.3% for the week, respectively. This is the worst five-day start to a new year for the stock market ever.
Trading in January historically tends to be positive more often than not simply because the end-of-year selling (i.e., tax-loss selling) that occurred for tax purposes in December is now over. You may have heard this referred to as the "January Effect." January is also the month where we begin to get a look at fourth-quarter (and thus holiday-based) earnings reports, which tend to be the beefiest for the service and consumer-oriented sectors. All told, 39 of the past 66 January's for the S&P 500 have ended higher. The start to this January, though, has left a lot to be desired.
Three questions every investor should be asking themselves
Whether it's uncertainties with China's economy, North Korea's purported hydrogen bomb test, or weakening commodity prices led by oil, some traders are ready to run for the hills. But, instead of crawling under the sheets to hide from the sea of red arrows, consider asking yourself the following three questions.
1. Do I need this money in the next one to three years?
The ultimate goal for investors is to try and find businesses that have a solid long-term outlook and could handily outperform their peers and the broader market. This does mean investors will deal with inevitable pullbacks in the stock market and recessions in the U.S. economy, but it also means plenty of opportunity to watch the businesses you own grow over time during extended periods of bullishness.
With the stock market plunging, what investors need to ask themselves is whether they need the money they're investing in the next one-to-three years. If the answer is yes, then what you're really doing is either trying to time the market or speculating, which can both be somewhat dangerous. If that's the case, you might be best off taking your investments off the table now.
However, if the money you've invested is designed to fund your retirement, and your retirement or need for this money is three or more years away, then there's really no immediate need to be alarmed. Substantial gains are derived by allowing time and compounding to do their work, and if you have time on your side, then this past week will be nothing more than a blip in your long-term investment history.
2. Does my investment thesis still hold water for the stocks in my portfolio?
If you don't have an immediate need for your invested money, then it's time to move on to the second important question that you'll want to ask yourself: Do you still believe in the businesses that you own?
The easiest way to establish whether you still believe in the long-term thesis of a company is to examine why you bought it in the first place. For instance, I purchased shares of Bank of America (BAC -0.59%) more than four years ago, and on numerous occasions I could have decided to part ways with my shares after they had doubled, and even tripled from my initial buy price. But I remain steadfast in my decision to hang on to my Bank of America shares. Why? Because the reasons I bought Bank of America stock haven't changed since November 2011.
Bank of America is still trading at a book value discount to its peers; it stands to benefit in a big way once its legal issues are safely put in the rearview mirror; and it should benefit from widening net interest margins as lending rates rise. These catalysts take time to be fully reflected in the company's share price, and a volatile stock market doesn't affect Bank of America's long-term game plan. In other words, my investment thesis in Bank of America is still intact, so its nearly 10% tumble last week really isn't anything for me to worry about.
What happens if you find a stock that no longer meets your original investment thesis? In this instance it could be time to consider selling. You certainly don't have to wait for a stock market correction to sell one or more of your holdings that no longer fits your investing thesis, but corrections such as the one we observed this past week do often serve as a good reminder that we should occasionally revisit our holdings and gauge whether our investment thesis still holds water.
3. Do I have money I can put to work right now?
The last question you should be asking yourself right now is whether you have money that can reasonably be put to work in the stock market. If you have no immediate need for your invested money, and the reasons you bought what you're currently holding in your investment portfolio still holds water, then it could be time to consider adding to those positions, or perhaps opening up new positions in businesses that meet your investment criteria.
Some of you might be scratching your heads and thinking, "But what if the market goes lower?" There's a simple answer to that question: You buy more.
Although there is no such thing as a given in the stock market, and it's inevitable that we'll all lose money on a stock trade at some point in our lives, the data is overwhelmingly in favor of buy-and-hold investors over the long-term. Since 1950, the S&P 500 has undergone 33 correction of 10% or more, not counting the most recent correction from a few months prior. In all 33 prior instances the S&P 500 eventually retraced the entirety of the correction lower and wound up hitting a new high. Sometimes it did so in a matter of weeks, and in some instances it took years to do so. However, one thing is clear: Corrections, while common, tend to be erased completely over time, and that's great news for the buy-and-hold investors.
Another interesting point comes from J.P. Morgan Asset Management. Using S&P 500 data from Lipper between Dec. 31, 1993 and Dec. 31, 2013, J.P. Morgan Asset Management showed that buy-and-hold investors who never sold earned better than a 480% return during this period. However, investors who had missed the 10 best trading days of the S&P 500 over this 20-year period (roughly 5,000 trading days) would have seen their return fall from more than 480% to just 191%. Miss the 30 best days out of around 5,000 and your return was less than 20%, or below 1% annualized over a 20-year period.
The lesson: If you have no immediate need for your invested money, you like what you own, and you have money to put to work right now, then there's probably not much you should be worried about right now regardless of how poorly the market began 2016.