When the Dow Jones Industrial Average takes its biggest single-day point loss ever, as it did earlier this week, investors sit up and take notice. The drop came after months of bull market action, bringing worries of long-term volatility and disruption.
Yet this isn’t a dire warning; it’s a plea for a return to normalcy. Every year — even strong years like 2017 — can have ups and downs, making it important to build a portfolio that strives to protects investments no matter what the market does. Here’s our take.
What Caused the Drop?
The drop started at the end of last week and continued through the first part of this week, with the Dow closing down 1,175 points on Monday. But there hasn’t been any single catalyst for this market change; instead, several factors contributed, including:
Stretched valuations within the equity market.
Inflated trading from high-volume software-based trade rather than investor behavior.
Uncertainty over interest rates. Last week’s job report brought news of the fastest increase in average hourly wages since 2009, raising concerns that the Fed might hike interest rates to cool inflation pressures.
Related uncertainty about the new Fed chair, Jerome Powell, who was sworn in earlier this week. He’s been on the board since 2012, and while market leaders generally feel they know what to expect from him, it’s still another change at a time of increased turmoil.
Low Volatility Is the Anomaly
It’s important to remember that this long bull market is unusual. The S&P, for example, had a fantastic year in 2017, in which its largest draw-down from peak to trough was less than 3 percent. But such performance is not common; prior years with double-digit growth frequently have draw-downs of 10 percent or more. In short, 2017 was an anomaly.
As a result, investors must wrestle with a tendency to go on high alert when the market corrects itself after a long run of gains. If the market shifts back into regular and expected corrections over the next year, a long-term strategy will be especially helpful. Now is a good time to reassess your organization’s expectations, investment strategy and tolerance for risk.
Hedge Funds May Provide Risk Management
Diversification is important for any portfolio, but in the face of market volatility, products designed with the objective of managing risk are especially useful, especially after a long stretch of growth. Hedge funds can help portfolios ride out normal fluctuations in the market, especially when paired with public equities. Last year, hedge funds were up just under 10 percent, but more importantly, they have historically helped protect investments when things dropped. During the Tech Bubble, the S&P 500 dropped 33 percent, while the HFRI Fund Weighted Composite was down just 1 percent.
The Next Steps
The latest market correction is a reminder that periodic draw-downs are standard in the market. Strong corporate earnings and economic growth are expected in the coming year, but the possibility of rising interest rates and other uncertainties may dampen some gains. Building a portfolio that can mitigate risk and ride out short- and long-term changes will be key in the coming months. Work with a partner who sees the long game and can help diversify your portfolio in a way that responds readily to your investment strategy.