Importance of Time and Diversification

This past December, stock prices fell -14%, bottoming out on 12/24/18 with a one-day loss of -2.7%. Watching your investments decline close to 15% in 16 days is scary, disconcerting and discouraging. With an aging bull market and increasing volatility, why stay invested?

In order to add value by market timing (owning more stocks in good times and selling stocks when the outlook is gloomy), one needs to anticipate market’s ups and downs. Every year, well respected market professionals try to forecast the annual return for the S&P 500 index. Below, we’ve compared the expert’s average annual return expectation versus the actual market returns over time.

As the chart demonstrates, analysts’ expected returns (blue bars) are a poor predictor of actual returns (orange bars). Expectations tend to group around long-term average and fail to predict market dips. In many years, expectations were wildly wrong.

Why can’t investors predict when the market is going to fall? Because market returns are driven by humans behavior which is inherently unpredictable. Predicting market returns is a fool’s errand.

Investors’ behavior during the Great Recession

Since 1990, the S&P 500 index has returned an average of 9.3% per year. Unfortunately, most investors did not achieve these results. According to studies , the main culprit for underperformance is investor behavior, primarily moving in herds and a fear of losses.

The Great Recession of 2008 is a great example of extreme disruption in markets and of widespread fear and anxiety. Recall how bad it was: bond markets collapsed, many brokerage firms went bankrupt, mortgage markets stopped trading and the U.S. Government had to step in to support markets and financial institutions on a scale not seen since 1930’s. Stock prices fell -37% in 2008 and another -24% through 3/9/09! Many investors, driven by a fear of greater losses, simply sold stocks to protect capital and, at the time, this felt reasonable. Unfortunately, this selling begat more selling which exacerbated and extended the downturn.

Investors often fail to achieve average market returns because they typically sell stocks near the bottom of market downturns in an attempt to avoid further losses. Unfortunately, this selling stocks during times of panic, turns a temporary loss into a permanent one. After hitting bottom on 3/9/2009, stocks rallied 66% as investors worst fears failed to materialize, and closed the year up +26%.

The panic around the Great Recession demonstrates investors’ tendency to act irrationally and overact to news. While predicting economic variables like inflation, GDP growth and earnings growth is difficult enough, anticipating investor response is pure speculation. To accurately and consistently predict future market returns forecasters need to accurately and consistently predict investors’ emotional and sometimes irrational responses to unknowable future news and events.

Daily returns matter

Adding to the unpredictability of stock markets is the speed at which prices fluctuate and adjust to new information. In periods of high volatility, daily price changes are sizable and can dramatically alter investor returns over time. The below chart demonstrates that over the last 15 years, if an investor missed the best 5 days of returns their returns were lower by almost 40%!

Attempting to time the market is made even more difficult by close proximity of the best and worst days in the market. Often trading around those days can be nearly impossible. (See prior Perspective: Predicting the stock market is a bad idea) The sharp bounce off the recent lows of late December through the end of January (+12.1% from 12/24) seems to reinforce this idea.

Time cures volatility

History has shown that for investors who remain invested over a market cycle, volatility is smoothed over time. In fact, the longer one remains invested the lower the likelihood of principal loss.

For investors with a one year horizon, returns can vary greatly from -43.3% to +53.6%. However, for investors with a 10-year horizon, the range of annualized returns shrinks to -3.4% to +19.5%, closer to the nearly three decade average of 9.3%. Staying invested for the long term is the best way to survive market dislocations similar to the Great Recession or the volatility seen this past December.

Asset allocation smoothes the ride

Another weapon investors can use against market volatility is diversification. During periods when stock markets fall, safer assets like quality bonds tend to outperform. (See perspective: Quality Bonds: an Underappreciated Role in Portfolios) The fourth quarter of 2018 is a great example of the benefits of diversification. During this period, the S&P 500 Index fell -13.5% and U.S. bonds rose 1.64%. While quality bonds do not boast high yields and high returns, they do tend to rise when investors panic and offer solid diversification benefits to portfolios.

For investors who are concerned with portfolio volatility, a diversified portfolio reduces overall risk and helps smooth markets ups and downs. In the following chart, we compare annualized returns (blue bar) and risk (orange bar) for selected investments back to 2004. The red diamond plots the risk-adjusted return, where a higher number indicates greater returns for each unit of risk. The portfolio on the far left is an “Asset Allocation” portfolio comprised of 25% bonds and 75% U.S. and international stocks. This portfolio has returns similar to those of other asset classes (in blue), but the risk is much lower as measured by the orange bar. Similarly, the red diamond which measures the return per risk, indicates that the “Asset Allocation” portfolio generates higher risk-adjusted returns through diversification than any of the other assets.

The well-known pitfalls of market timing show the importance of building diversified portfolios that help clients remain invested and confident throughout market downturns. Thoughtful financial planning incorporates future volatility and the potential for market weakness and can help support investors through more turbulent periods within investment markets. We understand that market volatility is unsettling and can make clients nervous, but we want to avoid emotional reactionary errors that turn a temporary loss into a permanent one. In market downturns, it is important to focus on the long term and those parts of the portfolio that are providing diversification. This focus is critical for clients to achieve their financial goals and investment success.

 

Note: All charts are sourced from Bloomberg

Note regarding last chart: “Asset Allocation” is comprised of 25% Barclays U.S. Bond Aggregate Index, 50% S&P 500 Index, 15% MSCI EAFE Index, 5% MSCI Emerging Markets Index, 2.5% Dow Jones U.S. Select REIT Index and 2.5% Alerian MLP Index

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