Stock market explained: Why the Dow and S&P are acting wild in 2018 — and what you can do about it

It’s natural to pay attention to the stock market when it sustains historic climbs or drops — and to generally ignore it the rest of the time. But by tuning in only as dramatic moves are afoot, you risk making a poor financial decision, driven by fear or greed rather than careful reflection and smart planning.

So, if you’ve been following market news this week: First take a deep breath.

Yes, as it was widely reported, the Dow Jones industrial average had its worst day in six years Monday and saw the largest single-day point drop in its history; the broader benchmark S&P 500 saw similar losses. One measure of stock volatility, or how widely and quickly prices fluctuate, also broke an intraday record in a mini-stock-market panic that then spread around the world, as Bloomberg reported.

The market then bounced around all week. It turned positive by close Tuesday; negative the following two days, with the Dow and S&P 500 down by more than 4% and 3% for the day, respectively, by Thursday’s close; and then positive again — both up more than 1% for the day — by Friday’s close.

So what gives: Was Monday’s drop (and the scary days that preceded it) a concerning preview of market weakness to come? Or are current fears overblown? And — most importantly — what can or should you do about it?

The very short answer, if you are relatively young and all of your investments are within a retirement account, is probably to do nothing: “If you’ve got a long term horizon, staying the course is likely ... right,” said Keith Bernhardt, vice president of retirement and college products at Fidelity.

But if that advice feels incomplete because you have deeper concerns about today’s market, want to be more proactive with your investments, or are deciding whether to keep, sell or double down on side investments you own beyond your retirement savings, read on. These three steps can help you react to a tumultuous market in a way that protects your money and leaves you financially stronger.

1. Look to history for context

Stock movements without proper context don’t tell you much, just like a water line falling an inch means something very different whether you’re in the middle of a flood or a drought. Right now, the S&P is still close to flat for 2018 since the start of the year. In other words, we are still far from a more worrisome pullback — like a 10% or more “correction” or 20% or more bear market drop — that could last months, not hours or days.

That said, this week’s stock market retreat is not nothing, and the fall is even visible on a chart that goes back 10 years, as this image shows from a report by Yardeni Research.

Unsurprisingly, worried analyses of market conditions are easy to come by. One major concern underlying investor skittishness is the possibility that the U.S. central bank, the Federal Reserve, will increase interest rates more than expected in 2018. The Fed has for years been buying up assets and keeping interest rates low to help heat up the economy: Low rates make it easier to borrow money, which means consumers buy more and employers hire more.

Now the economy is doing so well that investors worry the Fed will need to crank back the lever to prevent inflation: Cooling down economic activity by raising interest rates — because when unemployment gets too low, workers can more easily fight for high wages, in turn pushing up prices.

The upshot? If the Fed increases interest rates, relatively safe investments like government bonds would pay off more: tempting investors away from riskier assets like stocks. That, in turn, could splash cold water on the market.

“Investors are starting to think that the economy is going so strong, we might get inflation,” said Rebecca Walser, a certified financial planner and tax attorney. “People are going to pull money out of equities into fixed income bonds. Investors are just acting accordingly.”

Some market watchers are especially worried: In a recent column, executive editor of the Street Brian Sozzi wrote darkly that the “fun is just getting started” and the real culprit for recent volatility “has yet to surface.”

At least some caution is probably warranted. While markets are typically jittery when new Fed chairs are appointed, other factors in 2018 are more unprecedented: There’s the unusual combination of stimulative fiscal policy — a.k.a. inflation-boosting tax cuts — with potential interest rate hikes, a risky amount of leverage (a.k.a. borrowing) in the market and even concerns that a potential infrastructure plan could further spur inflation.

Then again, the economic indicators that may have partly triggered the market pullback suggest the U.S. economy is fundamentally strong — which should be good in the medium and long run for investors.

“The underlying real economy is on a stronger ground right now than it was at this time last year,” according to Satyam Panday, senior economist at S&P Global Ratings. “Borrowing a chapter from behavioral economists... Many analysts thought [the market] was a little rich, that it would fall. That makes more people think it’s going to fall because many others think it’s going to fall.”

In other words, human psychology provides as plausible an explanation as any for why the market fell this week, exacerbated by trading algorithms that amplify human behavior, a point made by New York Times reporter Binyamin Appelbaum on Twitter.

Assuming fundamentals remain strong, pullbacks can even be healthy, and analysts have suggested stocks have been overdue for one. Investor Barry Ritholtz even argued last year in an interview with Mic that younger investors should be “rooting for a market crash,” because it could present an opportunity to buy stocks for cheaper than usual.

In an emailed statement this week, Bankrate chief financial analyst Greg McBride argued that the recent pullback is one of those opportunities. “Market corrections are normal, no matter how nerve-racking they are at the time,” said McBride. “As economies around the world are improving, this means higher interest rates and less stimulus from central banks. That’s why investors are throwing a hissy-fit... If the market is falling, that means it’s now on sale.”

So how do you take advantage of that “sale” — while still protecting against the chance that it’s not a sale at all?

2. Customize your financial plan

If the market fall didn’t hurt you much because you own little in stocks, you’re in good company. In fact, barely half of Americans own any equities to begin with, and the top quintile of households own more than 90% of stocks, according to one analysis by a New York University researcher.

But before you celebrate mostly or completely sitting out the market dip, remember that avoiding owning stocks is a costly mistake. A person who saves an impressive 15% of income annually over the course of their career can still expect to lose out on up to $3 million in retirement income if they keep all their holdings in cash rather than stocks, a report from NerdWallet found.

In other words, a market pullback is a good moment to ask yourself, “Am I investing enough for retirement?” That’s both because increasing your saving rate means you will not need to rely as much on rip-roaring stock returns, and because you might get lucky and end up buying stocks on sale.

“When it comes to the levers a millennial investor can pull, saving more is the most important one,” said Bernhardt.

At least some young investors seem to have caught on, according to a recent report from Fidelity: The company estimates that the median millennial is on track to have about 78% of the money they’ll need in retirement. While that’s less than what boomers can expect — which is closer to 86% — it’s better than what Gen X is on track for.

Assuming you do decide to finally begin or ramp up your retirement investments, focus first on an appropriate asset allocation plan for your portfolio: If you have many years before retirement, you’ll want to choose a mix that is risky enough to grow (a.k.a. with more stocks than bonds) while including enough bond exposure to soften the blow when equities drop.

Once you choose your mix — say, 80% stocks and 20% bonds — you may need to rebalance once or twice a year to lock in gains, prevent portfolio drift and make sure your risk exposure doesn’t increase or decrease too much. Some investments, like target date funds, do all that hard work for you by automatically rebalancing and getting more conservative as you age.

For younger or less experienced investors especially, the good thing about a pullback like Monday’s is that sticking it out can teach you greater resilience, said Chris White, an investment manager and co-author of Working with the Emotional Investor: Financial Psychology for Wealth Managers.

“With major market moves, you first need to make an assessment in terms of how much risk tolerance you have.” White said. “If you’ve just started two years ago, you need to be staying the course. This correction has really been a test of your mettle, not the stock market’s mettle.”

Now: This is all well and good if your main investment goal is retirement, and that is many years away. But what if you are saving for a nearer-term need — like buying a home or having a baby — within the next 10 years?

3. Learn the tricks that make the most of good times and bad

Let’s say your savings goal is for a big purchase in the next year or so. Can you afford a negative short-term return? Make sure you’re comfortable with the hypothetical possibility of 2018 being a flat market for stocks (like in 2015) — or worse. Ask yourself: If I lose money, will I wish I had kept my cash in a high-interest savings account, rather than a brokerage account?

On the other hand, if your time horizon is further out — more like five to 10 years — and you can truly afford some risk (because, say, you already have a fat emergency fund) then you likely have a wider range of options for appropriate investments during a market pullback.

For one, you can get a little aspirational. Investor Josh Brown says he likes to weather any market downturns by making a list of his favorite stocks that he regrets missing out on, along with what he perceives to be an absurdly low price for them. Then, he places what’s called a “stop order” that purchases those stocks only if they reach his dream price.

The reason, he writes, is it gives him psychological momentum and something to root for when everyone else is acting like the sky is falling. Personal finance writer Carl Richards has a similar trick: Whenever he’s tempted to do something rash because of scary headlines, he puts $5 back into the market.

On the other hand, if your goal is less about buying dips — and more about protecting your downside — you’ll want to focus on the kinds of investments that do relatively well when the market is strong and hold up even better during recessions and downturns.

Those might include sector-specific stocks in utilities, consumer staples and health care, categories that are hardier than — say — tech stocks, since people tend to keep using electricity, needing medicine and shopping at discount stores like Dollar Tree and Walmart even during tough times.

For more diversification, there are also “safer” low-volatility, high-dividend funds that throw off income and hedge against market risk. To protect against inflation risk, you might also invest a little in commodities, which tend to outperform under inflationary conditions.

And other old standbys that risk-averse investors love include government bonds (already seeing a rise in popularity) and gold. For those that are seriously bearish, a very small slice of your portfolio could even go to a fund that directly hedges against a market drop by moving inversely to the S&P.

Yet, even as you map out a well-researched plan, remember: No single investment strategy is foolproof through all market conditions, which is good reason to set up a balanced portfolio — and then forget it, as they say.

After all, the best rules of thumb to follow are simple: Money invested in a diversified basket of stocks will likely grow if you wait long enough and aren’t tempted to sell at a loss out of fear. If you truly can’t afford a loss, don’t put that cash in stocks, and definitely don’t put it in bitcoin; there are plenty of high-yielding savings accounts out there to use instead.

And if you are able to afford a little risk? Read our guides on how to set up a retirement or brokerage account — and practice your rebalancing skills.

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Feb. 9, 2018, 4:15 p.m. Eastern: This story has been updated.