How Will Investors Handle The Market Correction?

Have investors learned how to recognise and handle market downturns?

They certainly have the tools available now, in the form of information and analysis to help identify when risk of a downturn becomes high, and when support levels have been broken indicating a correction has begun. And the availability of ‘inverse’ mutual funds and ETFs provides the opportunity to not only avoid losses, but to make gains from market declines.

In many respects, rather than being feared,  market corrections and bear markets offer better opportunities for profits than booming bull markets.

That’s because the market usually goes down faster in corrections than it went up in the previous positive period. In corrections the market often loses six months to a year of previous gains in a matter of a couple of months. In bear markets, several years of previous gains can be lost in a year or less. Therefore, gains from downside positions are usually made more quickly in declining markets than gains from upside positions were made in the previous rising market.

But the actions of public investors managing their own money through market corrections and bear markets is not encouraging.

A report in 2001 by Dalbar Inc., a leading financial services research firm, showed that from 1984-2002 the average annual return of the S&P 500 was 12.2%, and the average return of equity mutual funds was 9.3%. But because of their tendency to buy in, sell out, and switch around at the wrong times, the average return of investors in those funds was only 2.6%.

Not much has changed in the decade since.

Dalbar released a similar study in March of last year. It indicated that investors do well in bull markets, and can even outperform the market. The study showed that the average equity mutual fund investor made a huge 32.2% in the bull market of 2009, compared to a gain of 26.4% for the S&P 500.

However, the bad news is that the performance through bull and bear markets remained dismal.

Last year’s report showed that while investors made that spectacular gain of 32.2% in 2009, over the 20-year period, through bull and bear markets, they averaged only 3.2% per year.

The small improvement to 3.2% from the average 2.6% gain shown in the 2001 study, prompted the president of Dalbar to say that “the moderately improving results indicate that investors seem to be learning hard lessons from the past 15 years, absorbing the message that markets move in cycles.”

But I have to wonder. The slightly better long-term performance in the recent study was still extremely dismal, and included the big 32.2% gain in 2009. What will the long-term performance show after the next downturn?

It’s clear that investors can do well indeed in bull markets, but just as clear that they struggle with how to handle market downturns, giving back most of their previously made gains.

Studies seem to indicate that most investors react to market downturns by doing nothing, hoping the damage will not be too great, and if it becomes too great, by acting only then to protect their portfolios. Obviously, they’d do much better if they learned to handle both sides of the market’s cycles.

Meanwhile, I believe a significant correction is currently underway, but that it’s not too late to take action.

After being down for six straight weeks, the market is quite oversold short-term and probably due for a brief rally off of that oversold condition.

If I am correct that the market has further to go on the downside intermediate-term, but likely to experience a short-term oversold rally, such a rally would provide another opportunity to sell into the strength and even take downside positions.

In the interest of full disclosure my market indicators triggered an intermediate-term sell signal on the market on May 8, and I and my subscribers have had positions since in two ‘inverse’ ETFs, the ProShares Short Russell 2000, symbol RWM, and the ProShares Short S&P 500, symbol SH, with profits averaging 6% on the positions so far, (while the S&P 500 has now given back about 6% of its previous gains for the year). And it is my intention to add to my downside positions in selected ‘inverse’ funds in any short-term rally that develops.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.