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When Things Go “Bump” In The Night

This past week, investors were bluntly reminded that financial markets can be quite volatile. As we awoke Thursday morning, Banco Espirito Santo announced that loan losses could put the bank at risk for running short on capital.

For Americans, this should have been a nonevent. Most of us have never heard of Espirito Santo and are not even aware it is one of the largest banks in Portugal. For all intents and purposes, Portugal could be the dark side of the moon on most days.

However, on this small shred of news, the Portuguese bank dropped in price by 36 percent, and the ripple effect pulled the Dow Jones Industrial Average down 180 points during the day.

As you digested this news, what did you do? How did you react?

Did you sell? Did you buy? Or did you just sit tight?

Although the U.S. stock markets have performed amazingly well since 2009, no one should believe that violent volatility is permanently on vacation. This is especially true for traditional, fixed-income investors who have placed money in the stock markets desperately hoping for a return that will outpace taxes and inflation.

Over the past 85 years, the S&P 500 has fallen by at least 20 percent on 20 different occasions. As such, over long market cycles, all stock investors should recognize a 20 percent drop will happen on average once every 4.25 years. Additionally, over the past 50 years, the S&P 500 has dropped as much as 37 percent in one year and gained more than 50 percent in one year. It is a bumpy ride.

Compounding matters, consider that over the past year, the U.S. stock markets have increased more than 20 percent, but corporate earnings are up only 2 or 3 percent. This means investors are paying increasingly more for their investments. As such, market valuations are now in the 95th percentile (they have been more expensive only 5 percent of the time).

Knowing this, the smart investor will not only expect bouts of significant volatility but also plan to benefit from them. Furthermore, the trigger event will most likely be something unexpected. The issues of the past will not be the same culprits in the future.

Additionally, there will be some supposed expert claiming he or she can accurately predict the future. If someone can, he or she has not proven able to do so yet. As such, trying to time the market continues to be a fool's game.

With this framework, recognize there will be a market correction. It is not a matter of if but when.

What matters most is why you - and you alone - are investing. Don't worry about your Uncle Harry or your neighbor and don't worry about what the supposed experts are saying.

Make sure you have at least six months of emergency money available at all times with zero volatility to your principal.

If you are comfortable with the fact that stock market investing is a volatile endeavor requiring immense patience, then remember that owning stock is owning a business. If you own one share of stock, behave as if you own the entire company.

Imagine you own all of H-E-B, Academy or Blue Bell Creameries and then a bank in Portugal blows up. Are you going to sell your wonderful business at a fire sale price? Of course not. Similarly, if the S&P 500 falls by 20 percent, will the owners of any of these businesses run out the door selling to the first person available? Not a chance.

Finally, ask yourself one last question: If you are investing in publicly traded securities and the market drops, are you willing to buy more of what you own? If not, then you really need to reconsider what you own in the first place.

Rational business owners, of one share or all shares, are patient and focused on what matters most - long-term wealth creation. This is true of all businesses, whether private or public.

Dave Sather is a Victoria certified financial planner and owner of Sather Financial Group. His column, Money Matters, publishes every other Wednesday.

Originally published July 15, 2014, Victoria Advocate