The S&P 500 Index closed 2021 at 4,766. On January 24, 2022, it hit a low of 4,223, a drop of 11.4%, qualifying as a correction (the conventional definition of a correction is a drop of at least 10%). Drops of this magnitude can cause investors’ stomachs to roil, often leading to panicked selling. Investors might be able to avoid that mistake if they understood that drops of that magnitude occur fairly frequently – they are “normal.”
To demonstrate this point, in its monthly field guide, Avantis showed that over the period 1926-2021, the S&P 500 experienced 29 declines of at least 10% – about once every four years. The median drop among this sample was -20.1%, and the median length of time it took for the market to return to its previous high was 194 trading days (the fastest time to recovery was just 50 days). Drops of at least 5% occurred 90 times (almost once per year on average), with an average decline of 8.9% and the average time to recovery of 62 days. Drops of at least 20% (the conventional definition of a bear market) occurred 15 times (about once every six years), with an average decline of 28.2% and the average time to recovery of 369 days (just over a year).
Significant declines are not rare events. They happen fairly frequently, and in many cases, markets recover reasonably quickly. In other words, normal times include sharp market declines and periods of higher anxiety that should be borne with equanimity, as the evidence demonstrates that efforts to time the market are highly unlikely to prove productive. Knowing your financial history will help you keep your equanimity.
Since 1950 there were nine months when the S&P 500 Index lost at least 10%. The worst loss, -21.5%, was in October 1987, and the average loss was -13.7%. Over the next three, six and 12 months, the S&P 500 Index provided total returns of 9.5%, 16.4% and 26.6%, respectively. Investors who abandoned their plans due to panicked selling not only missed out on those great returns, but they were then faced with the extremely difficult decision of determining when it was safe to get back in. That’s one of the problems with market timing – you have to be right twice, not once. Return
You can also keep your equanimity during sharp declines if you learn to think of bear markets as necessary evils. A “necessary evil” can be defined as an unpleasant necessity, something that is undesirable but needed to achieve a result. An example of a necessary evil is taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.
Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (the benchmark riskless instrument). Since stocks are riskier, the only logical explanation for investing in them is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (i.e., the expected always occurred), investing in stocks would not entail any risk – and there would be no risk premium. In fact, in 25 of the 96 years from 1926 through 2021, or 26% of the time, the S&P 500 Index produced negative returns.
The very fact that investors have experienced large losses (such as the 89% decline from September 3, 1929, through July 8, 1932) leads them to price stocks with a large risk premium. From 1926 through 2021, the S&P has provided an annualized risk premium of 7.1% over one-month Treasury bills (10.4% versus 3.3%). If the losses investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk investors perceive, the higher the price they are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.
To demonstrate the imperative of keeping your equanimity during sharp declines, consider the following example. To earn the 16.3% return provided by the CRSP U.S. Total Market Index over the last 10 calendar years (2012-2021), you would have had to stay disciplined and endure 14 drawdowns of at least 5%, four of which were greater than 10%.
Market declines are a necessary evil and the very reason the stock market has provided the large risk premium and the high returns investors can earn. But there is another important point investors need to understand about market declines. Investors in the accumulation phase of their careers should view such periods not just as a necessary evil but also as a good thing. The reason is that large declines provide those investors (at least those who have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those in the withdrawal phase (such as retirees) who should fear sharp declines because withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, those investors have less ability to take risk, which should be built into their plan.
Smart investors know that while they can’t control markets, they can follow Warren Buffett’s sage advice to avoid timing the market, and the key to being able to do so is to control one’s temperament: “The most important quality for an investor is temperament, not intellect.” If you don’t have a plan, immediately develop one. Make sure it anticipates sharp declines and outlines what actions you will take when they occur (doing so when you are not under the stress that such periods create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of adhering to it when you are tested by the emotions caused by both bull and bear markets. And then stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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