Talk about a hangover! The New Year began with a giant headache in financial markets around the world, led by declines in stocks, oil and high-yield bonds. Media outlets used terms such as “bloodbath” and “financial Armageddon” to describe what (so far) has been a garden-variety price correction that began in the summer of 2015.
All this hyperbole aside, let us focus on the difference between price volatility and permanent loss.
Permanent loss occurs in four ways.
If you buy a stock, the company goes bankrupt and the stock goes to zero, that is permanent loss. Bad outcomes such as this in concentrated stock holdings are possible, but highly improbable, when using proper diversification and broad index-like investments. The odds of thousands of companies, located in dozens of countries, going broke simultaneously are very low.
Overuse of margin and leverage is the second cause. If you buy too many stocks on credit, you are almost certain to have a margin call at the worst possible time. Not only are you forced to sell low and cause permanent damage, but you may also still end up owing the borrowed money. I remember getting a margin call in October 1987. The market regained all its losses by the new year, but I was cured of margin investing forever.
The third cause of permanent loss is emotional — it’s what psychologists now refer to as behavioral finance. If you get nervous about daily fluctuations in stock prices that cause you to sell out in a panic, you may not have the temperament for the market. That is fine — just don’t invest in stocks. If you do, plan for a temporary 14 to 15 percent decline every year, and a 30 percent average decline one year in six. I’m not saying it’s pleasant, but it’s normal when seeking higher returns on your risk capital.
Finally, there is always the possibility a financial calamity will occur, and money will be no good, and all financial assets will become worthless. Predicting this outcome is a popular pastime. The doomsday crowd keeps pitching. They have been partially right once in a generation or so. If this does indeed happen, food, water and shelter will be higher on the priority list than savings-account balances and stock valuations.
You can prevent three of these four causes. Your retirement and long-term standard of living may depend on it.
Mark Daly is managing director and investment officer at Daly & Vachek Investment Consulting Group of Wells Fargo Advisors. 208-333-1433