Putting a Stock Market Decline in Perspective

If the stock market didn't go down on occasion, sometimes dramatically, then you would not experience the positive long-term results that have historically occurred. How is this possible?

Stock returns in the long run have been quite compelling because of many factors, such as a growing profits. But another factor is something known as the "risk premium."

Think of it this way. A 10 year U.S. Treasury bond is paying around 2% a year. This is not much of a return, especially after inflation and taxes. The trade-off is knowing that you will likely receive the stated interest payments and get your money back at maturity. You just don't get paid much for certainty.

Stocks have no such certainty. The returns can be quite volatile, as we are now experiencing. Although you may realize a lower return, you have the opportunity to get paid more over time for taking on risk.

To paraphrase an esteemed colleague of mine, the real issue is not market volatility, but the risk of paying too much for an asset. To the extent the large drop in stock prices has been greater than stocks' underlying fundamental value warrants, it is likely the market is less risky today than a few weeks ago, at least in the long-term.

Investors demand higher returns from riskier assets to compensate them for investing in something that can periodically lose a good chunk of its value. The key is hanging in there.