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 begins 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 than 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 to bonds
Now let’s look at Dan, an imaginary 60-year-old investor who wants to retire and buy an annuity or switch to 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:
Have no more than 10% of a retirement portfolio in shares for each year remaining before buying an annuity (or swapping into bonds, cash etc.)
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 doesn’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.
Thanks for the article John, a lot of useful points to take away from it. Personally, the Psychology of investing is a large challenge and this article covers ground in a manner that others don’t. Appreciated.
You’re not alone Matt! Investing psychology is difficult for almost everyone. Luckily the solution is simple (focus on corporate fundamentals and things like dividends rather than prices) but it isn’t always easy.
Good article John
As Corporal Jones would say, don’t panic! In the long run the market moves in an upwards direction, subject to some caveats that it can move sideways for quite a while as well as crash every so often. But why would things be any different to the last crash in 2008 or even 2000. They come and go, sit tight, if you are in the investing stage then take the opportunity to buy some investments cheap in the sale.
Hi Garety, that’s exactly right. Although when I think of “Don’t Panic!” I think of The Hitchiker’s Guide to the Galaxy rather than Dad’s Army. But the sentiment is the same!
I think irrational behaviour follows when the market undergoes a correction and your financial position is such that you are unable to absorb this loss when the paper value of your holding plummets.
The moral of the story is not invest more than you can afford to lose as prices can swing from highs to low. As John Maynard Keynes famously said:
“Markets can remain irrational longer than you can remain solvent”
Hi Reg
“The moral of the story is not to invest more than you can afford to lose”
That sounds like a good idea but it comes at a price. Many people don’t want to ‘lose’ anything, so they put their long-term savings into cash rather than the stock market. It may seem like they’re not ‘losing’ anything, but that’s not true. They are almost guaranteed to make a loss relative to where their savings would have ended up (over say 10, 20 or 30 years) if they’d put the money into the stock market.
For me the moral of the story is to have an appropriate time-horizon. If your horizon is 10+ year’s you’re highly unlikely to lose anything in the stock market. In other words, if you invest in the stock market today you are almost guaranteed to receive a positive return over 10 years or more, and probably a return far better than you’d get from cash.
You just have to accept these occasional ‘paper’ losses which are about as real as the tooth fairy.
Hi John,
I agree with what you are saying in principle. However, it depends on an individuals circumstance.
If you need instant access to that cash it would be imprudent to invest in the stock market. Simply because stocks are subject to wild swings on a short-term basis whilst hard cash will devalue at a rate of 2.5% annually. Therefore if you put in £3,000 into the stock market and you need this cash next year it could be worth £2,000 whilst in hard cash, at worst it will only devalue by £75. For an emergency fund, it’s not the best place to put your cash in fact if you leave your cash in instant access cash ISA it’s a far less risky proposition and with a 1.3% interest rate, you reduce the rate of inflation to just 1.2%.
The stock market should only be considered if you can do without this cash for a decade realistically speaking.
Hi Reg
Okay, I see what you mean. Yes, I agree with your final sentiment entirely: The stock market is only for money you absolutely don’t need for at least a decade.
“The moral of the story is not invest more than you can afford to lose”
This is quoted a lot. But it’s a cheap and often worthless, thrown away comment. Personally, and like may people, I have my SIPP invested in stocks and shares. Like most people I can’t afford to lose this money else I’d be very poor in retirement. So, from this comment I should not invest in the stock market …
Really? You really want me NOT to invest my life savings in the stock market in case it crashes and I lose all my money? The moral is really to know your risk tolerance over your investment time frame and invest accordingly.
Something that can help you get through the dips is remembering that your SIPP is tax free and so a 40% (in my case) paper loss is better than putting my cash in a regular savings account 🙂
Sentiment and moral has become extremely gloomy in past 2-3 weeks, this sell-off is wearing down even the most hardcore bulls. Everywhere I turn I read negative/bearish calls in articles and comments.
I am also quite demoralized at this point and im 50/50 on whether I should sell everything and go to cash or just hold. and rough it out.
“Global growth is slowing”
“US china trade wars”
“Rising US interest rates”
The thing that im sure is weighing on everyone’s mind is that there hasn’t been a big “crash” in a while now and since we’ve had periodic crashes in stocks for the last century, we must surely be due one soon. ( gamblers fallacy logic )
Hi Kindke, gamblers fallacy is exactly what that sounds like.
In the UK, market valuations are very reasonable, so any crash (which seems unlikely in my opinion, but obviously not impossible) would very likely be an outstanding buying opportunity for long-term investors.
Thanks for a great article with some great examples. I completely agree with your point on living off dividends but I think we have to recognise that not everyone can afford to buy enough to do that. I also think that the Early Retirement Now blog makes some good points about the potential pitfalls of moving into bonds as you near retirement, particularly for those seeking to do so earlier than the norm. Worth a read as a counter opinion even if you intimately discount it 😊
Personally if I was going to sell shares to generate income (i.e. pension pot not large enough to live off dividends) then I would sell a big chunk of my fund on day one and buy an annuity. At least that way you know what income you’re getting for the rest of your life, unlike the much riskier option of selling shares to generate today’s income.
But obviously what’s right for each investor can vary a lot.
There is a flaw in the notion that living merely off dividends is somehow a less risky strategy and will protect you in a major bear market. When a brutal bear strikes in the midst of a recession, dividends get ruthlessly cut and can go down by 50%. It is just that people have not seen this in the last decade where there has not been the kind of environment they might think dividends will protect them from.
Dividends do not come of off a fundamentally different magic tree than the overall returns of a stock – they come from the allocation of earnings to either reinvestment and growth in the value of the business or distribution to shareholders. It is a fallacy to think that the undistributed earnings do not show up in the total return – they do but it can take 12-18 months for the market to realise the value. Capital markets are reasonably efficient in this sort of time frame and value being created is usually recognised. I invest for total return and have been pretty successful compared to the standard dividend yield indices. There is an interesting article by terry Smith in a recent FT which can be read here without a subscription : https://www.fundsmith.co.uk/news/article/2018/10/03/financial-times—busting-the-myths-of-investment-who-needs-income
Investing for total return does require a cash buffer to allow you to avoid selling shares during unfavourable market conditions and something between 18 months to 3 years of cash as a buffer should work to address this and in my view produce better results than just relying on dividends.
Hi Lemsip, I think we more or less agree once we lay out the details.
I also invest for total return. Dividend yields and dividend growth must both be taken into account.
I agree that a cash buffer is very sensible because even in good times, monthly and annual dividend payments can go down as well as up.
I just prefer to live off dividends and not sell shares because it massively reduces the risk that I’ll run out of money, as dividends are typically (although not always) spare cash that businesses don’t need.
As for 50% dividend declines in a recession, I would say yes in the case of individual companies, but less likely (although far from impossible) for a diversified portfolio.
Looking at Robert Shiller’s 100+ years of US data, the US real (inflation-adjusted) dividend suffered:
31% decline between 1876 and 1880
27% decline from 1885 to 1891
30% decline from 1894 to 1898
53% decline from 1911 to 1920 (World War 1)
45% decline from 1930 to 1935 (Great Depression)
45% decline again around 1940 to 1947 (World War 2)
25% decline from 1966 to 1986 (70’s stagflation)
25% decline from 2008 to 2010 (great financial crisis)
So you’re right to point out that relying on dividends isn’t without risk.
However, total return investing wouldn’t have provided any protection because stock prices collapsed far more than dividends in all those cases. So selling shares to make up for the falling dividends would have resulted in a very rapid depletion of capital for all but the most over-capitalised investors.
I think the lesson is that in major bear markets (great financial crisis, 70’s stagflation, World Wars, Great Depression) everything goes to hell in a handbasket and there’s little you can do about it if you don’t have other sources of income such as an annuity, bonds, property or whatever.
So perhaps the real less is to diversify outside of equities when you retire, which is obviously quite sensible. Or to buy an annuity for at least part of your retirement income. Or to be flexible enough so that a 50% decline in dividend (or total return) income isn’t the end of the world.
Personally, if I do ever fully retire then I would just try to live off dividends, but I think there needs to be a margin of safety. In other words, I wouldn’t retire if my dividends just about covered my minimum living standard. Instead, I would rather the dividend be more than enough to cover a reasonably comfortable retirement, so if there was another Great Depression and a 50% market-wide reduction in dividends I could 1) reduce my living costs by eating baked beans, etc. and 2) sell a small amount of capital, perhaps 1% or so per year, to top up the reduced dividend income.
But hopefully I’ll be dead before we suffer another economic trauma such as the Great Depression or a World War.
The stability of the dividends depends on the type of business you have invested in. Certain companies through thick and thin will pay decent increasing dividends due to having a durable competitive advantage. These are discussed as having a wide moat whilst others have a narrow moat or no moat at all.
In economic crisis/warfare it is the company with a narrow moat/no moat at all that disappears first or slashes its dividends.
I want to give examples of two companies operating in the retail sector both with a long history of dividends:
Marks and Spencer once had a market cap similar to Wal-Mart has produced an erratic dividend yield going from high to low to high. In 2006 it gave out 14p and now 18.7p for 2017. Clearly, with inflation, it’s actually gone down the yield. Management has cited tough retail condition and reduce in consumer spending for the woeful results. The truth is it’s lost its way and needs to change its game.
Wal-Mart, on the other hand, has increased its annual cash dividend every year since first declaring a $0.05 per share annual dividend in March 1974.
Given the fact that between 1974 to 2018 a 44 year period we have been through some tough economic times and security issues this goes to show that a good company can swim even when the tide is down.
The trick is to find a good company and pay a fair price. Having read M&S biography the management of this company had serious ego issues. Wal-Mart, on the other hand, has always kept a lean and hungry ethos making it a formidable company. As long as you buy a good company at a sensible price you’ll do fine if you hold on to the stock for the long run.
Market Correction should really be seen as the stock market equivalent of Black Friday (but not Black Thursday check out Wikipedia if you want to know why)!
Hi Reg, excellent point. That’s why I try to have a healthy dose of defensive stocks in my portfolio, even though they’re relatively expensive at the moment compared to cyclicals.
As for the M&S Management’s ego, I used to work at its old head office in Baker Street and the executive offices there were very plush; lots of expensive-looking artwork etc. That building was sold off in 2005 and rightly so as it looked like an expensive perk for top managers rather than a cost effective allocation of capital for shareholders.
Hi John,
M&S epitomises the worst corporate governance in all regards. According to the book I read the management treated the company as their personal fiefdom. It was more important that they grew the company at the cost of the investors capital rather than return it back to its investors. Despite the fact that it was clear that it made no sense from a business point only from an ego perspective.
Had management realised in the 80s that they had reached the pinnacle and should just focus on maintaining this position with minimal investment. All this extra capital could have been returned back to the shareholders in the form of dividends or share buybacks.
Chances are M&S would have still remained profitable and in a stronger position as a smaller capital base normally forces management to focus maximising returns and acts as a deterrent from empire building fallacy.
The reason why I have commented on M&S is to demonstrate the fact that qualitatively the company was failing in the 80s as it was straying from its core expertise. However, the company was in rude health so the strong balance sheet covered up the strategic mistakes of the management of the company, which would haunt it from the late 90s.
All this was obvious to those looking at the company from a strategic point of view. This should serve as a reminder that as an investor we have to scrutinise the companies strategy to determine if it is worthwhile investing in. The qualitative information is what imbues the investors capital to generate good returns for the future. As all the quantitative data acts as a record of what they have achieved in the past.
Hi Reg, your M&S thoughts are eeirely similar to my own.
All of my SIPP and ISA investments are in accumulating funds which automatically reinvest dividends. This means that harvesting dividends can only be achieved by selling units. Surely this is ultimately the same, although I recognise that working out how much to sell is not so straightforward. Any thoughts?
Hi John
I agree with all of this
there is a blog in the US, which advises keeping 3 – 5 years living expenses in cash – to avoid having to sell in bear markets and keeping 10 – 15 % of funds allocated to equity investment in cash or short term bonds as “dry powder” to invest in market corrections; wait for 10 – 20% correction to invest part of the equity investment (optionality)
http://www.investingparexc.com/
I still prefer a total return approach with these caveats, because in the longer term I think that this gives you a better result – but each to their own