With all the volatility in the markets lately I think a lot of investors wonder if they should be conservative right now. Some may even wonder if they should be in the market at all?
Well, there's not a lot of statistics to measure what's happening these days. I actually did a small research project over the weekend to see over the past 20 years how often we've had similar economic and market conditions as well as what happened as a result.
I share the results in the video, but here's the quick rundown:
- From an economic perspective we're not in a "danger zone" - yet. But we are very close. In the previous two times our economy has gotten as week as it is trending toward today the US stock market has declined significantly (it was similar in 2001 as well as 2007-2008).
- The trend in the market is very similar to three other occasions from the past 20 years. 1998, 2000, and 2007 (December of 2007 and January of 2008 to be more precise). In the 12 months following those trends the market returned +27.8%, -13.6%, and -40.5%.
- However, in 1998 the trend reversed after a 15% decline and the market went up nearly 25% after that.
- And, in 2001 and 2008 the markets full losses before recovery exceeded 50% each time.
So in a nutshell, the biggest risk to investors in a climate like we're in today is to be fully invested in stocks. There is a risk however that by being smart (conservative and defensive) investors may miss a potential rally to the tune of 10-15%.
I would suspect the bigger risk though is the way we handle our emotions. As investors it's very easy to feel "slighted" when our portfolios lag the market on it's way up. Even if we know there's only a 33% chance of a rally we feel like we should be getting the markets upside all or most of the time. It's also very easy to forget that missing the large drops is far more important in the long run than the short term rallies. It's probably most frustrating to take the initial losses too when a downward trend starts developing.
Often times when this happens our gut instinct is negative. Emotions get the better of us. When that happens just consider the very hypothetical scenario below - and don't let it happen to you:
[table id=2 /]
What the table illustrates is three pretty bad situations. Each each of the hypothetical scenarios we see 5 years of bad, choppy returns. The middle column though shows how an investor would fare if they got 50% of the markets upside when it is in an uptrend and 80% of the markets downside for the first two quarters (that's 6 months) of a market downtrend. If the downtrend lasted more than two quarters the return goes to zero. The third column shows what would happen if an investor grew tired of limited upside and still 80% of downside for up to 6 months, so they "switched" to just market type performance after a couple of years.
The end result is of course they have high risk (as measured by the standard deviation of returns) and really bad performance.
Another little data nugget for numbers lovers:
In the "risk managed returns" hypothetical example the investor would have trailed "the market" in 17 of the 20 quarters by total account balance and in 10 of the 20 quarters measured individually. The total return is also only slightly higher after 20 years - but the risk adjusted return (return/risk) is more than double. So from a geeky statistical perspective it is a wildly more successful approach to investing.
I should point out that I'm not illustrating the investment philosophy of my firm here - just what happens psychologically to many investors. Balanced, boring investing is hard to stick with. There can be prolonged time periods of more than one year where the philosophy doesn't seem to be working. Then a market decline of large proportions happens and the investor with the boring portfolio is finally vindicated.
Large market declines are part of investing. Understanding when they are likely to happen and then doing something about it paramount.
Just in case I wasn't 100% clear - the example above is purely hypothetical. There is no guarantee of any system or method to avoid market risk entirely. Investors should not rely on this blog for specific investment recommendations - it is simply a place I share my research and thoughts on the market and investing in a very general sense.
I'll post again at least once more this week. If there's anything you'd like to see me research for future posts just use the comment feature below and I'll add it to my list.