The Dow Jones Industrial Average (DJIA) set a recovery high on January 19, 2010, closing at 10,725.43.  In the final three days of last week, however, the DJIA declined 552 points, or -5.15%, to close at 10,172.98.  It was the sharpest weekly decline in stocks since October 2008.

First, some basics:  all investing entails risks. Prudent people manage the risk by diversifying and staying within their comfort zone.  Outside the comfort zone, people make impulsive decisions out of fear. Successful investors use ongoing rational analysis and exercise patience and discipline.  As a financial planner, investment broker and advisor, I assist in your decision-making based on what I know of investments, your investment goals, cash flow needs, and risk tolerance.

Especially in a zero-interest rate environment the old adage is true: no risk, no reward.  Investing in stocks and stock funds is inherently risky, but it can also be quite rewarding.  The trick is to do it in a rational, patient manner, taking advantage of volatility rather than being whipsawed by it.

In the week ended January 11, volatility, as measured by the VIX index, often called the “fear index”, reached its lowest level in 20 months. This indicates that investors had become complacent as to the risk of investing in stocks.  In the three days just ended, however, the VIX increased 26.7%, indicating a quick return to a normal level of fear on the part of stock investors.  The emotional pendulum of investors tends to move between extremes, however.  Because the fear had subsided to such a low level, it now seems plausible that the fear could spike much higher in the days to come.

In the language of Wall Street, a selloff in stocks in the midst of a generally rising trend is called a “correction”.  A correction puts fear back in the hearts of investors and provides value-oriented investors an entry point at more reasonable prices. The current correction began Wednesday, January 20.  It will end when the major stock indexes resume their long-term uptrend.

If, however, the correction brings stock indexes down 20% or more from their recent closing highs, it would indicate that the primary trend in stocks has changed to the downside.  A 20% decline in the DJIA would bring that index down to a close at or below 8,580.  I don’t think that is likely at present.

I believe that the current correction will be the deepest of any since the market bottom of March 9, 2009, and I would not be surprised to see the DJIA fall approximately 10% from its recent high close.  That would put the Dow Jones Industrial Average at 9,652.89.

Stocks tend to fall faster than they rise, and fear tends to come quickly but dissipate slowly.  Therefore, I do not expect stock indexes to bounce back and exceed their recent highs for several months.  If you bought stock or stock funds recently, you now must exercise patience if you wish to realize potential gains.

It is time once again for investors to hunker down, evaluate their current positions, and make sure they are comfortable with the level of risk in their portfolios.  Corrections are often a good time to “trade up”, selling lower quality stocks or funds and buying higher quality issues.  When both are on sale, why not buy quality?

If you will need principal from your investments in the very near future, you have probably already missed your best selling opportunity.  In a medium-term correction, as I think this one may turn out to be, there will be sharp rallies of a day or two before sellers probe the downside again.  Use these little rallies to raise the cash you need in the next 60 or 90 days.

Investors sitting on cash and looking to get into stocks or add to positions should be watching closely for a good entry point. The best time to buy is when others are selling in panic.  No one knows the exact bottom until it is past, but we all can read and listen to the public media. When financial news reports lead you to conclude that all hope is lost for stocks and the economy, the bottom may be near. “Bleak” and “dismal” are the adjectives you should be listening for.  When those adjectives prevail, I would anticipate a bounce, and, if we’re lucky, a resumption of the primary upward trend. 

In the meantime I remain available to review your investment portfolio with you and discuss your current needs, goals, and tolerance for risk.  With so many investment advisors to choose from, I appreciate the opportunity to be of service.