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Stephen High
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Richard Flohr
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Recently, the stock market has experienced significant volatility. Should we be surprised, or should we have expected it? What does this volatility mean to an educated investor?
The historical evidence
Consider the following concerning the historical distribution of stock returns:
- From 1926 – 2006, 23 out of the 81 years produced negative returns. In 10 of those years, the losses were greater than 10 percent. In five of the years, the losses exceeded 20 percent. In two of the years, the losses exceeded 30 percent. In one year, the loss exceeded 40 percent.
- During the same period, out of 324 quarters, there were 27 in which losses exceeded 10 percent. There were also seven quarters when losses exceeded 20 percent, and there were two quarters when losses exceeded 30 percent.
What the data is telling us is that stocks are risky assets, and the risks show up fairly frequently. The data also tells us that severe losses are fairly common. In fact, the risk of severe losses is why stocks have provided higher returns historically than have bonds. On average, investors are risk averse. To entice them to take the risks of equity investing, stocks must be priced to provide high expected returns. And it is not a question of if the risks will show up. The only questions (to which no one has the answers) are when the risks will show up, how sharp the declines will be, and when they will end.
The anatomy of a "crisis"
Some bear markets are caused by specific events such as what occurred on September 11, 2001, or the oil crisis of 1973. These events are random and cannot be forecasted, but others follow a fairly consistent pattern, as follows.
When economic times are good, investors become more willing to take risks. Prices begin to rise. The longer the times remain good, the more confident investors become, and the more risk they become willing to take. Eventually stocks may even become “priced for perfection.” Eventually the risks do show up. Losses appear, credit tightens, margin calls have to be met and a flight-to-quality ensues. We might say that “the tipping point” was reached. Prices don’t just fall, they often collapse and a vicious cycle develops as selling begets more selling. Some investors are forced to sell to meet margin calls and others simply panic.
When risks show up
During bear markets, all risky assets have a strong tendency to become highly correlated. Thus, while global diversification across equity asset classes with low correlation is the prudent strategy because it reduces risk over the long term, during crises this benefit “takes a holiday.” The only safe havens during such periods are fixed income investments of the highest quality (for example, Treasuries, government agency securities). Riskier fixed income assets such as junk bonds and emerging market bonds also suffer from flights-to-quality and flights-to-liquidity. This is why the prudent strategy is to limit fixed income holdings to securities of the highest credit quality.
It is also important to note that the risks of hedge funds, which supposedly offer the benefit of low correlation, tend to rise during crises. The reason is that many hedge funds attempt to achieve high returns by investing in risky and illiquid assets; therefore, just when you need them to provide their so-called hedge, the risk appears. This is exactly what happened in the summer of 1998, with an encore performance in the summer of 2007, which is just one of the many reasons why investors should avoid hedge funds.
These crises also show why investors should avoid strategies that employ leverage. Leverage works well until risk shows up. Then the use of leverage often leads to the inability to wait out a bear market because margin calls must be met. Leverage has been the factor leading to the demise of many investment strategies.
Timing the market
The evidence on efforts to successfully time the market is compelling. For example, one study of 100 large pension funds and their experience with market timing found that, “While all the funds had engaged in at least some market timing, not one of the funds had improved its rate of return as a result.”1
Why such poor results? Keep in mind that when you try to time the market you have to be right not just once, but twice. You have to sell at the right time, and you also have to get back in at the right time.
We saw earlier that out of the 324 quarters from 1926 through 2006, there were 27 in which losses exceeded 10 percent. Out of those 27 quarters, 16 were followed by quarters when the S&P 500 Index rose at least 5 percent. There were also seven quarters when it rose at least 10 percent, four when it rose at least 20 percent, three when it rose at least 30 percent and two when it rose at least 80 percent. Yes, 80 percent!
Thus, following quarters when the market fell, at least 10 percent, the next quarter it rose at least 5 percent almost 60 percent of the time. There were also three other quarters when the market rose, though less than 5 percent. Over 70 percent of the time after experiencing a quarter of a sharp decline, the market actually rose.
Evidence such as this is why legendary investor Peter Lynch stated, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections, than has been lost in corrections themselves.”2
Summary
Life is just too short for individuals to spend time worrying about their portfolio. If investors make sure that they don’t take too much risk, they will be able to rebalance (buy more of the very investments that have performed the worst) in the face of large losses. Some investors let emotions drive their decisions and end up buying high and selling low. On the other hand, prudent investors, who stay disciplined and rebalance, are clearly adhering to a superior strategy.
Smart investors recognize the fact that stocks are risky investments, no matter the time horizon. They also know that they cannot predict when the bear market will emerge from its hibernation or how large the losses will be. They know that just as battles are won in the planning stage, the winning investment strategy is to have a well-developed investment plan in the form of an investment policy statement; however, having such a plan is not the only condition necessary for investment success. The successful investor has the discipline to stick to the plan.
A successful investor is like a postage stamp. The postage stamp does only one thing, but it does it exceedingly well. It adheres to its package until it reaches its destination. To be successful, investors must have the discipline to avoid having their well-developed plan end up in the trash heap of emotions.
1 Charles Ellis, Investment Policy, Irwin, 1993.
2 Peter Lynch, Fear of Crashing. Worth, September 1995.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2007, Buckingham Family of Financial Services. Excerpts reprinted with permission.
Kraft Asset Management, LLC, is affiliated with the Buckingham Family of Financial Services.
