http://www.youtube.com/watch?v=Oowl5eq-NLM 

I had a good talk yesterday with two journalists whom I respect quite a bit, Pimm Fox and Carol Massar of Bloomberg Radio’s Taking Stock. We started off discussing the markets, why things were down, and what might happen, and then they asked an excellent question: what should an investor do, and why?

It was so good a question, in fact, that I didn’t have a good, short answer. So much depends on the investor’s plan, his or her time frame, risk tolerance, and so on and so forth that it’s almost impossible to come up with a succinct response.

With the market’s recent declines, it’s not surprising that the doomsayers are showing up again. In the past couple of days, I’ve heard from several advisors whose clients have received e-mails or read articles that highlight all of the things going wrong, forecasting the imminent collapse of, well, just about everything. Perhaps you’ve received or seen one of these publications yourself.

Let’s start with the real risks. Stock markets worldwide seem to be in the midst of a correction. Here in the U.S., we appear to face the risk of further declines. This has been reinforced by recent economic news that was somewhat less positive than expected. We could be seeing a stock market correction and a slowdown in the recovery. These are real risks, and they shouldn’t be ignored or minimized. They are, however, normal risks, signifying that the economy has recovered to a more normal place. They are not catastrophic risks.

I gave a talk here at Commonwealth yesterday, updating our staff about the economy and the markets. One point kept coming up over and over—that we’re now at or close to normal levels of growth, as of the mid-2000s, which was a pretty good time. In some areas, such as employment, we still haven’t returned to normal levels in total, but getting normal growth is the first step.

(As an aside, this type of internal training and education is part of what makes Commonwealth exceptional. Everyone is welcome, and these talks happen all the time on many different subjects.)

A couple of bad days recently have rattled many investors. After the strong run-up in the stock market to the end of last year and the continued strong economic reports, many expected the market would continue to perform strongly. Instead, we have had stability for most of the month, with small declines followed by recoveries—until the past week, when we’ve seen one of the worst sell-offs in the past couple of years. What gives?

The key phrase there is “the past couple of years.” So far, we have seen, at worst, about a 4-percent decline, and as of this morning, the market has ticked back up. Is this something we should be worried about?

In the past couple of weeks, there have been several indications of a slowdown in the U.S. recovery, and international markets have shown weakness. Over the past week, we’ve seen that translate to drops in U.S. interest rates and declines in the stock market. Since we ended last year, thinking there was nothing but blue skies ahead, clouds have rolled in. Should we be worried? And if so, about what?

Let’s start by looking at the U.S. economy. The first cloud was the shockingly weak jobs number three weeks ago: only 74,000 jobs were reported as created, against an expectation of around 200,000. I analyzed that figure and concluded, based on other data, that it was a false signal, due primarily to severe weather. Nonetheless, I saw it as something that should signal caution.

— Guest post from Peter Essele, senior investment research analyst

There’s been quite a bit of speculation lately regarding the long-term direction of interest rates, particularly around movements on the short end. We’ve heard numerous specialists’ thoughts on the subject, and most believe the Fed won’t hike rates on the short end until late 2015, at the earliest. Although they make for good sound bites on CNBC, there really doesn’t seem to be much basis for many of these prognostications, so we decided to put pen to paper to assess the direction of rates.

Today, I want to tie together my posts over the past week. If you remember, we talked about the mismatch between current return expectations and what history suggests as likely, and what investors could do about it. I talked about truly diversified asset allocation and regular rebalancing as a required base strategy, along with possibly using some other risk-reduction technique, like market timing, to guard against large drawdowns. This discussion was interrupted, in a very timely way, by a response to turbulence in emerging markets and a relatively large (in recent terms) market decline in the U.S. on Friday.

One of the themes of the past few posts (and of my market commentary in general over the last several months) has been the need for caution and a willingness to recognize—and plan for—risk factors.

One way to plan for them is to decide, ahead of time, what conditions would make you change your asset allocations—in this case, to dial back on risk—and then what conditions would make you reverse that again.

In the last several posts, we’ve talked about two problems. The first is that drawdowns—which is to say, losses—is a better risk measure for most investors, and something to be avoided. Portfolios should therefore be designed to avoid drawdowns as much as possible. The second problem is that market valuations are very high right now, which both raises the risk of drawdowns (back to point 1) and also makes it very likely that future returns will be below what most people expect.

Stepping back a bit, what both of these points address is the problem of terminal failure—that is, of simply not achieving your investment goals at the end of whatever your target time period is. Drawdowns can make an investor unwilling to take enough risk to reach his or her goal, while returns below expectations may also mean the goal isn’t met, even if the investor is willing to bear the risk. This is the real problem we face as investors and advisors: taking enough risk to meet our goals, but making sure that our expectations will be met in return for taking that risk.