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As Midterms Loom, Take the Long Road Home

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Developing a long-term financial plan is more than just about managing money -- it's a blueprint for defining a family's values and mapping out a sensible lifestyle. Without such a barometer, behavioral scientists warn that investors are prone to 'shooting from the hip' as markets toss-and-turn.

With political debate heating up regarding this year's midterm elections, a well-conceived investment plan can prove especially valuable. After all, this election cycle is bringing pundits out of the woodwork. Investors are being inundated with a cavalcade of fear-mongering and market-timing advice. And it's coming from all directions, including journalists at established publications like the Wall Street Journal, Financial Times, Barron's and MarketWatch.

Before voters go to the polls on Nov. 6, it's probably safe to expect more screaming headlines. Based on what we've seen in the past, many will proclaim this election as a final pitchfork in the stock market's upward advance. Others will caution of impending doom and gloom across a range of different types of assets and global markets.

Given such a media onslaught, it's natural for some investors to feel a little vulnerable, particularly for those who haven't talked to an IFA advisor about charting their financial futures through a complimentary and comprehensive financial plan. In times like these, we like to remind our clients that market upheavals, whether fueled by political or macroeconomic uncertainties, aren't isolated events. 

(Indeed, just this spring -- when global trade tensions and partisan politics were dominating financial news reports -- we offered an evidence-based video looking at what's happened in the past when investors didn't follow an all-weather investment plan.)

Instead of listening to the roar of the crowd, we urge investors to study an abundance of peer-reviewed academic research from Nobel Laureates like Eugene Fama and Harry Markowitz. This wealth of evidence shows that making knee-jerk reactions during bouts of market volatility isn't a productive strategy. In order to avoid market whiplashes, we've found the best remedy is to develop a long-range passive investment plan, then stick to it.

With a new election cycle stroking fears of a correction in stocks, IFA's advisors thought it'd be worthwhile to take a look at historic returns during periods of acute market stress. For such a review, we turned to research by Dimensional Fund Advisors. (See chart above.) This study uses a statistically significant data set (nearly 90 years) and focuses on return patterns across global stock markets. It also remains neutral to circumstance, which in effect gives less cover to doomsayers who raise red flags about isolated events over relatively short timeframes. 

Between 1926 and June 2015, DFA's analysts find that large-cap stock prices dropped into correction territory (10% or more) on 28 different occasions. But so-called head fakes, when blue chips in the S&P 500 fell by 5% or less, were even more abundant -- 262 separate events. The same patterns of numerous stock dips, both big and small, were documented across international large caps and emerging markets.

Even though such research shows that recent market volatility isn't an anomaly, many investors will no doubt keep viewing price movements as unique and isolated events. In such a vacuum, any sense of fear and loathing about upcoming election cycles can obfuscate the notion of market-timing and make it seem like a fairly seductive proposition.

"But successful market-timing is a two-step process: determining when to sell stocks and when to buy them back," notes DFA's analysts in reviewing long-term portfolio churning data.

Gambling that luck will strike twice hasn't been a very smart bet, these researchers suggest. They conclude that no matter whether stocks advanced or declined by 10% or more over this lengthy period, prices always reflect: "the collective assessment of the future by millions of market participants" and "the expectation that equities in both the U.S. and markets around the world have positive expected returns."

Mark Hebner, IFA's president and founder, has recently put together a piece examining the fundamental mechanics of price discovery. ("The Hebner Model: A Framework for How Markets Work.")

In this article, he points out that Nobel Laureate Fama says that at any point in time "prices reflect all available information so that … it is basically impossible to beat the market … because investors are always paying fair prices."

Hebner adds: "So the task of investors is simplified -- they just have to decide how much risk they want to take to get more or less expected return."

The foundation of any holistic financial planning process, of course, is an in-depth assessment of each passive investor's need -- or, lack thereof -- to expose a portfolio to differing levels of market volatility.

As a result, our advice is to focus on understanding your capacity to handle market risk. Along those lines, we've developed a Risk Capacity Survey. This online tool is based on advances in behavioral finance and portfolio optimization techniques. Its aim is to help investors quantify risk-and-return parameters in their own terms, a critical step in evolving from a reactionary trader to a thoughtful and patient index investor.