The Dow dropped 266 points yesterday. The "Fear Index" or VIX is up. Is the sky falling yet? No! Of course, after surviving the near-collapse of the world financial system only 5 years ago, it is a fair question.
Let us remember that almost every year has a 5-10% correction, and we are overdue. I've been hoping for one for some time now. We're only down 4.5% from our high last month. The longer we wait, the greater the correction. So, bring it on! It will be good for the stock market in the long run.
How do I know this is not the "big one," as we saw in 2008/9? The basis of Modern Portfolio Theory teaches us that higher returns are available with lower risk if the portfolio is diversified by asset classes instead of by stocks. In other words, a portfolio of 25 healthcare stocks is definitely NOT diversified. A portfolio of different asset classes, such as large company stocks, small company stocks, international stocks, long-term bonds, short-term bonds, cash, gold, real estate is much better diversified. The reason is correlation. While all healthcare stocks are likely to move in the same direction by approximately the same amounts, stocks will usually move differently than gold or real estate, because they are not correlated. However, during the global financial collapse five years ago, everything became correlated, which is a fancy way of saying everything goes up or down at the same time. When everybody sells everything and heads for the exit, asset classes become correlated, and this is bad.
Today, we see some stocks moving up, some nations moving up, and some bonds moving up, despite the fact that the vast majority of stocks are falling. Different asset classes are behaving differently, which is normal. Correlations are still working, which means that asset classes move independently of each other. When they don't work, it is OK to get nervous . . . but not now! Embrace the short-term pain!
Let us remember that almost every year has a 5-10% correction, and we are overdue. I've been hoping for one for some time now. We're only down 4.5% from our high last month. The longer we wait, the greater the correction. So, bring it on! It will be good for the stock market in the long run.
How do I know this is not the "big one," as we saw in 2008/9? The basis of Modern Portfolio Theory teaches us that higher returns are available with lower risk if the portfolio is diversified by asset classes instead of by stocks. In other words, a portfolio of 25 healthcare stocks is definitely NOT diversified. A portfolio of different asset classes, such as large company stocks, small company stocks, international stocks, long-term bonds, short-term bonds, cash, gold, real estate is much better diversified. The reason is correlation. While all healthcare stocks are likely to move in the same direction by approximately the same amounts, stocks will usually move differently than gold or real estate, because they are not correlated. However, during the global financial collapse five years ago, everything became correlated, which is a fancy way of saying everything goes up or down at the same time. When everybody sells everything and heads for the exit, asset classes become correlated, and this is bad.
Today, we see some stocks moving up, some nations moving up, and some bonds moving up, despite the fact that the vast majority of stocks are falling. Different asset classes are behaving differently, which is normal. Correlations are still working, which means that asset classes move independently of each other. When they don't work, it is OK to get nervous . . . but not now! Embrace the short-term pain!
