Swedroe: Reality Check For Investors

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:

• Surprisingly, there were almost as many negative first quarters (33 of them, or 37%) as there were negative Januarys. In 22 of those 33 years (67%) the final nine months were able to produce positive returns. It’s important to note, however, that not every year with a negative January also had a negative first quarter. The average return for the 33 remaining nine-month periods after a negative first quarter was 11.9% (1.9 percentage points higher than the annualized return over the full period).
• The five best nine-month periods in years following a negative first quarter occurred in 1933 (79.2%), 1935 (64.1%), 1938 (61.1%), 2009 (42.1%) and 1980 (38.0%).
• The three most recent years in which there was a negative first quarter posted the following returns over their ensuing nine months: 2005 (7.2%), 2008 (-30.4%) and 2009 (42.1%).

Again, it’s important to recognize there were years in which the nine months following a negative first quarter produced negative returns. The worst five years were 2008 (-30.4%), 1974 (-24.3%), 1973 (-10.3%), 1940 (-9.0%) and 1966 (-7.5%).

Again, note that the fifth-best year for an ensuing nine months provided a gain greater than the loss in the year with the single worst remaining final three quarters.

We’ll now perform the same analysis to show what has happened after the S&P 500 Index produced a negative return for the first half of the year. The historical evidence demonstrates that:

• There were a total of 31 years (34%) in which the S&P 500 Index produced a negative return for the first half of the year. In 16 of those 31 years (52%) the index produced a positive return over the final six months. The average return for the 31 final six-month periods was 3.1%.
• The five best final six-month periods in years during which the first half produced negative returns occurred in 1932 (62.0%), 1982 (31.7%), 1970 (29.1%), 2010 (23.3%) and 1949 (23.2%).
• The three most recent years with negative returns in the first half produced the following returns over the final half of the year: 2005 (5.8%), 2008 (-28.5%) and 2010 (23.3%).

Again, it’s important to point out that there were years in which the six months following a negative first half did produce negative returns. The worst five years were 1931 (-42.8%), 1937 (-29%), 2008 (-28.5%), 1930 (-22.7%) and 1974 (-18.1%).

Our final look is at what has occurred after the first nine months of the year produced a negative return for the S&P 500 Index. The historical evidence demonstrates that:

• There were a total of 24 years (27%) in which the S&P 500 Index produced a negative return over the first nine months. In 15 of those 24 years (63%), the index produced a positive return over the final three months. The average return for the 24 final quarters was 1.1%.
• The five best final quarters in years following a negative return over the first nine months occurred in 1962 (13.3%), 2011 (11.8%), 2001 (10.7%), 1970 (10.4%) and 1960 (9.6%).
• The three most recent years with negative returns in the first nine months produced the following results over the final quarter: 2008 (-21.9%), 2011 (11.8%) and 2015 (7.0%).

Once again, we’ll note that there were years in which some very poor final quarters followed a negative first nine months, specifically 2008 (-21.9%), 1937 (-21.4%), 1930 (-15.8%), 1931 (-13.8%) and 1973 (-9.2%).

Conclusion

Unfortunately, the academic research on the behavior of individual investors isn’t encouraging. Mistakes such as recency bias, herding and overconfidence in their ability to withstand the stress of bear markets (which results in panicked selling) leads individual investors to underperform not only the market, but also the very funds in which they invest (because they buy after periods of strong performance and sell after periods of poor performance).

What’s truly unfortunate is that investing can indeed be simple. All investors need to do in order to be successful is to have a well-thought-out plan—one that doesn’t take more risk than they have the ability, willingness and need to take; invest in low-cost, passively managed funds; and follow the advice of the investor most would say is the greatest of his time: Warren Buffett. Buffett implores invest to stay the course, never attempting to time the market. However, he adds that if you cannot resist temptation, at least be a buyer when others are panicking and selling, and be a seller when others are greedy.

Hopefully, the evidence presented here will help you to avoid catastrophizing, and instead allow you to envision that good outcomes are more likely. If you haven’t taken more risk than your stomach can handle, that should help you to adhere to your plan. In case it hasn’t been sufficient, perhaps these words of advice from another legendary investor, Peter Lynch, will prove helpful:

• “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
• “Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head, but the stomach that determines [your] fate.”
• “I can’t recall ever once having seen the name of a market timer on Forbes’s annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”

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Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.