Swedroe: Better To Face Correction

October 18, 2017

We have data for 91 calendar years (or 1,092 months) of U.S. investment returns over the period 1927 through 2016. The average monthly return to the S&P 500 has been 0.95%, and the average quarterly return was 3.0%. With that background, here’s a short, four-question quiz:

  1. If we remove the returns from the best 91 months (an average of just one month a year and 8.5% of the entire period), what is the average return of the remaining 1,001 months?
  2. What is the average return of those best-performing 91 months?
  3. If we remove the returns of the best-performing 91 quarters (an average of one quarter a year and 25% of the entire time period), what is the average return of the remaining 273 quarters?
  4. What is the average return of those best-performing 91 quarters?

What many investors don’t know is that most stock returns come in very short and unpredictable bursts. Which is why Charles Ellis offered this advice in his outstanding book, “Investment Policy”: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”
It also is likely why, in his 1991 annual report to shareholders, legendary investor Warren Buffett told investors: “We continue to make more money when snoring than when active,” and “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.” Later, in his 1996 annual report, Buffett added: “Inactivity strikes us as intelligent behavior.”

Returning to our quiz, the answers are:

  1. While the average month returned 0.95%, if we eliminate the best-performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1%). In other words, 8.5% of the months provided almost 100% of the returns.
  2. The best-performing 91 months, an average of just one month a year, earned an average return of 10.5%.
  3. While the average quarter returned of 3.0%, if we eliminate the best-performing 91 quarters, the remaining 273 quarters (three-fourths of the time period) actually lost money, providing an average return of -0.8%. In other words, just 25% of the period provided more than 100% of the returns.
  4. The best-performing 91 quarters, an average of just one quarter a year, earned an average return of 14.3%.

Despite this type of evidence, which makes clear how difficult market timing must be, one of the most popular beliefs held by individual investors is that timing stock markets is the winning strategy. After all, who doesn’t want to buy low, right at the end of a bear market, and sell high, just before the next bear market begins. Unfortunately, an idea is not responsible for the people who believe in it.

Pros Bad At Prediction

The evidence is very clear that professional mutual fund managers cannot predict the stock market. For example, in his famous book “A Random Walk down Wall Street,” Burton Malkiel cited a Goldman Sachs study that examined mutual funds’ cash holdings for the period 1970 through 1989.

In their efforts to time the market, fund managers raise cash holdings when they believe the market will decline and lower cash holdings when they become bullish. The study found that, over the period it examined, mutual fund managers miscalled all nine major turning points.

Legendary investor Peter Lynch offered yet another example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.

If that investor missed just the best 10 months (2% of them), his return fell 27%, to 8.3%. If the investor missed the best 20 months (or 4% of them), his return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (or just 8% of them), his return declined 76%, all the way to 2.7%.

In a September 1995 interview with Worth magazine, Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Investors should keep the preceding evidence—as well as advice against trying to time the market offered by investment legends such as Ellis, Buffett and Lynch—in mind whenever they hear warnings from “gurus” that the market is overvalued and a correction is surely coming.

This wisdom is especially timely with the Shiller CAPE 10 at 31 as I write this, almost double its long-term average. However, I would note that calls for a correction are nothing new.

For example, back in February 2013, with the CAPE 10 then at 22, Jeremy Grantham, a respected market strategist at GMO, wrote that “all global assets are once again becoming overpriced” and that some securities were “brutally overpriced.”

By November of that year, with the CAPE 10 at 24.6, he wrote: “The S&P 500 is approximately 75% overvalued.” But the market ignored Grantham, as well as other pessimists such as John Hussman and Marc Faber (Dr. Doom). From February 2013 through September 2017, the S&P 500 Index returned 14.2% (well above its long-term return of 10.0%) and posted a total return of 85.6%.


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