Swedroe: Reality Check For Investors

February 22, 2016

Possessing a well-thought-out asset allocation plan that takes into account your unique ability, willingness and need to take market risk is only the necessary condition for success in investing (unless you just happen to get very lucky). The sufficient condition is having the discipline to stay the course.

That’s certainly not easy to do when markets are crashing, and the only light at the end of the tunnel many can see is from the proverbial set of truck headlights coming the other way. That is why Warren Buffett has said that while investing is simple, it’s not easy.

The start to this year is a great example. Through Feb. 11, the S&P 500 Index lost more than 10%. Rapid moves such as these will cause almost all of us to worry to some degree or another. One reason is that our brains, no matter who we are, are programmed to react more strongly to bad news than to good news. We feel the pain of a loss much more strongly than we feel the joy of an equal-sized gain. Negative emotions dominate positive ones.

Don’t Catastrophize

Over more than 40 years of providing investment counsel to corporations, endowments and individual investors, I’ve learned that one of the keys to successful investing is to avoid the tendency to “catastrophize”—envisioning only the worst possible scenario.

It usually starts with a perfectly reasonable worry (like a slowing Chinese economy or dropping oil prices) and then, through incorrect assumptions, snowballs out of control. The way to avoid catastrophizing is to envision positive outcomes. To do that, it helps to know the history of market returns. Consider the following examples:

  • From 1973 through 1974, the S&P 500 Index lost a total of 37%. Over the next five years, it returned almost 15% per year. And over 25 years, it returned more than 17% per year.
  • From April 2000 through February 2003, the S&P 500 Index lost an even greater total—more than 41%. Then, from March 2003 through October 2007, the index returned more than 100%, providing an annualized return of more than 16%.
  • From November 2007 through February 2009, the S&P 500 Index lost a still-greater total— more than 46%. Then, from March 2009 through November 2015, the index returned 227%, or more than 19% per year.

Having knowledge of such good outcomes can help you avoid catastrophizing and stay disciplined. I recently presented the data showing returns to the S&P 500 Index for the remainder of the year in years in which the index produced a negative return during the first quarter, first half and first nine months.

I hope the following, deeper dive into the historical data, provided by my colleague, Dan Campbell, will help you envision good outcomes. The data covers the 90-year period from 1926 through 2015:

  • There were 34 years (38%) in which the S&P 500 Index produced negative returns in January. In 20 of those 34 years (59%), the index produced a positive return over the remaining 11 months, with the average return being 7%.
  • The five best 11-month periods in years following a negative January were 1935 (54.0%), 1928 (44.2%), 1927 (40.2%), 2009 (38.1%) and 2003 (32.2%).
  • The three most recent years with a negative January produced the following returns: 2010 (19.4%), 2014 (17.8%) and 2015 (4.5%).

Markets Tend To Rebound

While it’s important to not catastrophize, it is equally important to point out that there were also some very poor returns for the 11-month periods following a negative January. The five worst years were 2008 (-33.0%), 1974 (-25.8%), 2002 (-20.9%), 1973 (-13.3%) and 1969 (-7.9%).

Note that even the fifth-best year for a final 11 months produced a gain almost as high as the loss in the year with the single worst remaining final 11 months. It’s virtually impossible to capture the great returns without accepting the risk of the very poor ones.

We’ll now perform the same analysis to show what has occurred after the S&P 500 Index produced a negative return in the first quarter. The historical evidence demonstrates that:

'IWM' Assets Jump

Swedroe: Is Momentum Really Dead?

XLE & GLD Top Weekly Flows; DBEF's Assets Plunge

Swedroe: ‘Incredible Shrinking Alpha’ Continues

ETF.com Podcast: How Indexing Became Controversial