2018 has been a year of corrections for the UK stock market.
First we had a market correction (a decline of more than 10%) in January and now we’ve had another in October.
This has unsettled a lot of active investors. I know this because many of them have emailed me asking whether this is a) a good time to get out of the market or b) a good time to avoid putting more money in.
These are entirely sensible questions.
Investors want to avoid losses and it’s easy to see how a 10% decline today could turn into a full-blown bear market tomorrow.
However, despite their seemingly sensible nature, these questions highlight an underlying fear of market corrections which is almost entirely irrational.
This fear of market corrections is irrational because corrections are almost never a bad thing for sensible investors.
In fact, most of the time corrections are either irrelevant or they’re exactly what an investor should wish for.
To see why this is true, let’s take a look at some common scenarios in which investors might find themselves.
Scenario 1: When you’re more than a decade from retirement
Let’s start with Bob. Bob is a fictional 35-year old investor who is still in the accumulation or build-up phase of his investment lifecycle.
Bob is saving hard towards retirement, buying new shares with the 10% or so of his salary he’s able to save each month. He expects to retire about 20 years from now.
Bob’s investments are growing well and have more than doubled over the last five years.
However, the UK market has suddenly declined by more than 10%. The media machine swings into action, announcing “billions wiped shares“.
Bob begin to weep, realising that his dream of retiring early has been obliterated before his very eyes.
But then again, perhaps it hasn’t.
Bob invests directly in company shares, so he follows the Regulatory News Service or RNS announcements from those companies (for example, here’s the RNS feed for Tesco).
Bob should be asking himself:
- Have any of the companies I invest in released any updates during the correction?
- If so, have they mentioned a significant decline in earnings, revenues, or dividends?
If this market correction is like most market corrections then the answer is probably no. In most cases during market corrections, companies either say nothing at all or at least nothing bad.
And while there may be some bad news, it’s usually offset by other companies reporting good news (assuming Bob has a diverse portfolio).
So if companies in general are more or less unchanged during the correction, what has changed to drive share prices down by 10% or more?
The honest answer is that we can never really know. All we can say is that prices have changed and, for the most part, economic and corporate fundamentals haven’t.
Or as Professor Joel Greenblatt said in his book, The Magic Formula:
Stock prices move around wildly over very short periods of time. This does not mean that the values of the underlying companies have changed very much during that same period. In effect, the stock market acts very much like a crazy guy named Mr. Market.
So as someone who expects to be buying shares to build his retirement pot over the next twenty years, what should Bob do?
Well, what would you do if your local supermarket or favourite clothing store announced a 10% sale?
If you were going to buy food or clothing anyway then I’m pretty sure you’d be happy with a 10% sale.
In fact, you might even go out and buy more food or clothing that you normally would, precisely because the cost of those goods had fallen while their underlying value (i.e. their benefits to you) remained the same.
This is, in my opinion, how accumulating investors like Bob should view market corrections and bear markets.
In other words, market corrections give accumulating investors the opportunity to buy the same companies but at lower prices.
Of course, the market could fall further, but if it does then just use this mental image:
Your local supermarket is now running a 20%, 30% or even 50% sale. Is that better or worse than a 10% sale?
Obviously it’s better.
So for accumulating investors like Bob who have more than a decade to go before retirement, the further the market falls, the better.
And that’s something a certain Mr Buffett has said many times before:
“Anytime stocks go down I like it, because as far as I’m concerned I’m a net buyer of stocks. I’ve been buying stocks since I was 11 years old, so when stocks go down it’s good news, just like it’s good news when hamburgers go down or Coca-Cola goes down” – Warren Buffett
Scenario 2: When you’re less than a decade from buying an annuity or switching into bonds
Now let’s look at Dan, an imaginary 60-year old investor who wants to retire and buy an annuity or switch into bonds at 65. Over the last 20 years Dan has invested directly in individual shares and built up a healthy retirement fund, so he’s a relatively experienced investor.
Normally Dan wouldn’t worry about a market correction because he’s seen dozens of them before, and they’re almost always temporary and relatively short-lived.
Usually he sees market corrections as an opportunity to buy good companies at low prices.
But last week the market collapsed by 10% and because Dan is only a few years away from buying an annuity (or switching to bonds), he panics.
Dan’s highly stressed brain comes up with two alternatives:
- Sell all my shares now to avoid the potential 50% market decline that everyone seems to think is coming.
- Stay 100% invested in shares and hope for the best.
I would say that both of those options are bad, and here’s why:
Dan is within a few years of retiring and buying an annuity, so in my opinion Dan shouldn’t be heavily invested in the stock market in the first place.
Instead, he should gradually reduce his equity holdings as he approaches retirement.
This would reduce the amount of stress and uncertainty he has to put up with.
It also means he should be able to estimate the size of his annuity and retirement income more accurately as he approaches retirement.
Here’s one simple divestment rule which I expect to use if I ever decide to go down the annuity route:
Using this approach, ten years away from retirement Dan would be happy to be 100% invested in stocks.
But the following year he’d rebalance his portfolio so that no more than 90% of it was in stocks.
The other 10% could go into bonds, cash or anything else which is much less risky than the stock market.
The year after that Dan would rebalance stocks to 80% of his portfolio, then 70% and so on.
By the time Dan is almost retired, he should be almost out of equities and so any market correction would be just about irrelevant.
Scenario 3: When you’re less than a decade from living off your dividend income
Meg is 60 and wants to retire and live purely off dividends from 65 onwards.
As in the previous scenarios, the market declines by 10% in a week and the media go into their usual hyperactive panic (because that’s what gets views on the internet and on tv).
Does Meg panic?
No, of course she don’t.
If Meg is still buying shares with new savings, then her situation is the same as Bob’s in Scenario 1. In other words, shares are on sale and that’s a good thing.
If Meg has stopped adding new cash to the portfolio then there are still dividends to reinvest. This means she would still be a buyer, so shares are still on sale and that’s still a good thing.
In both cases, the market decline is likely to affect share prices rather than dividends.
As long as the total dividend from Meg’s portfolio isn’t going down (which is the case for the vast majority of market corrections) then share price declines are an opportunity to buy good companies with higher dividend yields.
Scenario 4: When you’re already living off your dividend income
Finally we have Lucy, a 60-year old who has already retired. She has a large portfolio of shares and lives off dividends alone.
Lucy doesn’t have to sell shares to fund her lifestyle, so short-term share price movements and market corrections are of almost no interest to her whatsoever.
I say ‘almost no interest’ because Lucy still actively manages her portfolio, so market corrections are an opportunity for her to sell expensive low yield holdings and reinvest the proceeds into cheaper high yield shares.
This helps her to drive up her dividend income, even though she isn’t adding any new savings to her retirement pot.
What Lucy cares about are the companies she owns and the dividends they pay; not whether their share prices are up or down by 10% this week or this month.
Market declines are usually good news or irrelevant news… but not always
For the most part then, investors should either ignore or welcome market corrections.
However, there is one group of investors who should care about market corrections.
These are investors who focus on ‘total returns’ rather than dividends.
When they’re accumulating funds, these total return investors select investments based on a combination of dividends and growth. That’s entirely sensible and it’s what I do.
Where we differ is that total return investors are often happy to sell shares to generate a retirement income, whereas I would rather live off dividends alone.
I think selling shares to fund a retirement income is a very risky strategy for a lot of people.
That’s because a lot of people overestimate their safe withdrawal rate.
It can seem quite safe and sensible to sell a few percent of your portfolio each year to top up your dividend income. After all, the stock market ‘should’ grow by an average of about 4% each year and you would effectively be turning that growth into additional income.
However, if there’s a major bear market then investors who sell shares to generate a fixed income are at risk of drawing down their portfolio too quickly.
I also think selling shares for income is also more stressful than relying on dividends alone.
That’s because the investor is concerned with the value of their shares (which are wildly volatile) and not just the dividends they produce (which are not).
That’s why my preference is to live off dividends alone, where the capital remains untouched and where the dividend is very likely to grow faster than inflation.
As a high yield investor, my portfolio‘s yield is higher than the 4% “safe withdrawal rate” anyway.
And since I have no intention of selling shares to generate an income, I am free to agree with Mr Buffett and see market corrections as an opportunity to buy better companies with higher yields, rather than as something to fear.