The big sell-off in the stock markets on Monday, February 5 was unusual but not unprecedented nor unexpected in percentage terms. The S&P 500 Index lost 4.1% on that day. A Page 1 article in the Wall Street Journal on the next day titled “What Should We Make of the Stock Price Drop” contained information about the frequency of large selloff’s. Here is a link to the article:
In a chart, the article shows that we get a movement (up or down) of 4% or greater about 0.6% of the time, which is about 1 trading day per year. In statistical terms, Monday’s 4.1% drop was a between 2 and 3 standard deviation event: 3 standard deviations mean some result is expected 99.7% of the time, so the 4.1% sell of wasn’t quite a 3 standard deviation event, but almost. This is based on actual data since 1964. So, you would expect not to have another 4.1% or greater move this year, if past performance is an accurate indicator. Or is it?
Author Nassim Nicholas Taleb would question whether you can rely on the statistics of the past to see what the future might be like. Taleb is famous for pointing out the concept of Fat Tails, which implies that unusual events like February 5 are really not that unusual. Weird stuff happens more frequently than you think, according to Taleb. Expect and prepare for weird stuff.
In a different WSJ article, also on February 6, a reporter asked former US Secretary of State Henry Kissinger for advice about writing a column about foreign affairs. Kissinger’s advice was one word: “Context”. That applies to the stock market, as well. Noting that the market has moved 4% or greater in a day about 1 trading day per year is useful as a context for the February 5 move. However, it doesn’t mean that we won’t have more frequent 4% moves in the future – just that they have happened only every so often in the past.
How to Prepare
Most investors made it through Monday’s selloff and lived. Only those that were heavily into shorting market volatility got really burned, but that’s an esoteric side of the trading universe. There will likely be more bumps along the way to hopeful recovery. I don’t think it is necessary to bubble-wrap your portfolio to prepare for every eventuality. That said, portfolios that were well-diversified among different asset classes (stocks, bonds, foreign, commodities, real estate) fared better as a whole during the selloff than did stocks-only portfolios. I believe it is best to prepare for 3 Sigma or fat tail events by being well diversified. Why is that? Because investors who sell an asset in a crisis move the money that they got from selling into another asset in another asset class that they perceive as being safer. Collectively, as many investors do the same thing, the price of that new asset will go up due to supply and demand.
The amount of the decline – 1,175 points on the Dow – got the headlines, but 4.1% is really not that unusual. When you get to the nosebleed section, a 4.1% fall seems like a really big fall, and you fall a long way. Don’t let the decline scare you away. The road can be bumpy. The flight can be turbulent. Use any metaphor you want. It is best to stay in the car or on the plane. Keep going. Stay invested. Stay diversified, and you will hopefully achieve your financial goals.