Swedroe: Volatility Threatens Discipline

This is my fourth article in a series devoted to helping investors stay disciplined in the face of market volatility—and even lengthy periods of underperformance by risky assets.

The first was a December 2015 post dealing with what I call “investment depression.” The second was a January post designed to help investors deal with the worst-ever five opening trading days to a year for the S&P 500 Index, titled “Keep Calm and Step Forward.” The third was a post earlier this month addressing the mystery of disappearing premiums, particularly the value premium.

As the market continued to fall, with the S&P 500 reaching a closing low of 1,829 points on Feb. 11, down 10.5% since the start of the year, I received an increasing number of calls from worried investors. My response was, and is, always the same: While we’d all like to believe there is someone out there who can protect us from bad things, no such person exists. All crystal balls are cloudy, including mine.

Thus, the winning strategy is to have a well-thought-plan that incorporates the virtual certainty that bear markets will arrive (and with a fair amount of frequency). In fact, of the 360 quarters since the year 1926, 31 of them (8.6%) saw the S&P 500 Index lose at least 10%. And in the 180 half-years since then, 19 of them (10.6%) saw the S&P lose at least 10%.

Keys To Discipline

My long experience as an investment advisor has taught me that there are two keys to being able to stay disciplined during bear markets and adhere to your plan. The first is that you don’t assume more risk than you have the ability, willingness and need to take. That means you must not be overconfident in your ability to withstand the stress caused by bear markets. Unfortunately, overconfidence is an all-too-human trait, and the easiest person to fool is yourself!

The second is to know your financial history. That knowledge will allow you to envision good outcomes and avoid the downward spiral I call investment depression, which often leads to panicked selling. With that concept in mind, I thought it would be helpful to review the historical evidence on the performance of the S&P 500 following periods of declines of 10% and 20%.

I believe most investors would be surprised to learn that in the 90-year period from 1926 through 2015, the S&P 500 Index lost at least 10% 152 times, and at least 20% 39 times. The frequency with which such losses occur is not only the reason that a good financial plan anticipates them, it’s also why investors demand a large premium for taking the risks of investing in stocks.

Historical Evidence

As mentioned above, the ability to withstand the stresses of a bear market is dependent on your ability to envision good outcomes. To help you do that, we’ll review the historical evidence on the annualized returns of the S&P 500 Index following declines of 10% and 20% over the ensuing one-, three- and five-year periods. The table below was provided by Dimensional Fund Advisors (DFA). (In the interest of full disclosure, my firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Note that three of the six data points show annualized returns that are even greater than the full- period return of 10.0%. In addition, none is all that far below 10.0%, and each is well above the returns on safe bonds.

DFA also looked at the same situations for international large-cap stocks for the 15-year period from 2001 through 2015. During this time frame, there were 31 periods in which the MSCI EAFE Index had losses of at least 10%, and nine periods in which it had losses of at least 20%.

In five of the six cases, the returns following these declines were above the 9.5% return of the MSCI EAFE Index over the entire period from 1970 through 2015.

And finally, DFA examined the evidence from emerging markets for the period 1999 through 2015. During this time frame, there were 49 periods in which the MSCI Emerging Markets Index had losses of at least 10%, and 16 periods in which it had losses of at least 20%.

In every case, the returns following these declines were well above the 10.5% return for the MSCI Emerging Markets Index for the entire period 1988 through 2015.

Conclusion

When we’re in the midst of a market downturn, and our stomachs are churning, we are prone to take action when inaction is the strategy most likely to deliver us the best result. Remember, for market timing to be successful, you have to be right not just once (knowing when to get out), but twice (because you also have to know when it’s safe to get back in).

So, before you jump to any conclusion as to what the future may hold, recalling the historical evidence presented here can be helpful in preventing a mistake that so many investors make—selling after periods of negative returns.

And if that’s insufficient, I suggest you remember Warren Buffett’s sage advice, which is to never time the market, but if you cannot resist that temptation, at least be a buyer when others are panicked and selling. Being able to resist your stomach’s cries of “GET ME OUT” is why Buffett has also said that investing is simple, but it’s not easy. And that’s why so few are successful.

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