Why Do We Put Up with This Wild Ride?
On days like today, in which all major U.S. stock indexes officially entered a bear market (commonly observed as a 20% decline in value since recent highs), many folks are asking themselves a perfectly reasonable question: “Why do we put up with this wild ride?” The purpose of this post, dear reader, is not to tell you whether or not it is a good time to buy stocks. The breadth of academic research on this subject is clear: market timing cannot be done well consistently. My goal in writing this post is to provide valuable and, just perhaps, stress-reducing context for what’s occurring in the markets.
Before doing so, however, let’s take a moment to recognize – above all – the human suffering that is occurring as a result of COVID-19. At the time of this writing, over 4,000 people have died, more than 100,000 human beings have been infected, and millions of lives have already been drastically affected around the globe.
Let’s start by perusing the chart below. To summarize, the blue mountains represent gains since a market bottom and the red valleys illustrate the depths of losses from a market peak to the bottom. All of the data is based on the S&P 500 index. The S&P 500 index tracks the 500 or so largest companies headquartered in the U.S. and covers about 80% of the total value of publicly traded stocks in our country. As such, it’s a good yardstick.
A common reaction from viewing this chart for the first time is something along the lines of ‘Wow, it sure doesn’t feel like that!’ For many, it probably seems like the red and blue areas are equal, or perhaps that the red area even exceeds the blue. After all, our brains are wired for loss aversion! Loss aversion – which simply means that we experience losses more dramatically than gains – is a core tenet of Prospect Theory. Prospect Theory was first espoused by Daniel Kahneman and Amos Tversky in 1979, and eventually won Kahneman the Nobel Peace Prize in Economics in 2002. This research explains why it feels more negative to lose $100,000 in your 401(k) than a gain of the same amount feels positive.
The human mind’s tendency toward loss aversion makes sense, doesn’t it? Let’s pretend you have $1,000 in your Venmo account and a friend offers you a wager with 50%-50% odds (essentially, a coin toss). If you win, your friend will send you $1,000 on the spot; if you lose, you send $1,000 to them right then and there, and your Venmo balance goes to $0. Few among us would be willing to take that bet (I certainly wouldn’t!). But how much would you be willing to risk for the possibility of instantly gaining $1,000? Is it $800? $500? $100? This is loss aversion at work. Two of the key elements of my work with clients are 1) understanding their unique personal and psychological views on risk/reward and 2) constructing portfolios that align with those views.
Here is a second interesting observation: The length of time each blue or red period lasts varies drastically. The blue periods of upswing lasted anywhere between 30 and 181 months. The longest bull market lasted five times longer than the shortest! Similarly, the red periods of bear markets lasted anywhere from 3 to 31 months, a full 10x difference! The takeaway for investors today is simple: Predicting when this bear market will end is impossible.
Now, let’s return to the original question: “Why do we put up with this wild ride?” The answer is more straightforward than it might seem. We endure the red so we can benefit from the blue. Whether we like it or not, market declines of 20% or more; bear markets are part of investing in stocks. For enduring that wild ride, however, the S&P 500 returned 10% annualized over the period shown in the above graphic. That return was in spite of those painful declines in red!
But what did this actually translate to in terms of dollars? After all, stocks dropped by 40% on multiple occasions since the beginning of this chart. How can an annualized return of 10% possibly catch-up? The key lies in compound interest. For example, $100,000 in the S&P 500 at the beginning of 1990 - a period that included one market decline of 45% and a second of 51% - grew to over $1.7 million by the end of 2019. For many families, benefiting from the potential investment growth of stocks is a crucial engine for achieving their goals.
To round out the discussion, let’s get specific in understanding how stocks historically performed following sharp market declines in the past. On average, what happened over the next 1, 3, and 5 years after other downturns of 10%, 15%, or 20%? The information in the chart below was compiled by professors Kenneth French and Eugene Fama, also a Nobel Laureate. The numbers speak volumes.
Periods in which cumulative return from peak is -10%, -15%, or -20% or lower and where a recovery of 10%, 15%, or 20% from trough has not yet occurred are considered downturns. For the 10% threshold, there are 3,442 observations for 1-year look-ahead, 3,396 observations for 3-year look-ahead, and 3,345 observations for 5-year look-ahead. For the 15% threshold, there are 3,175 observations for 1-year look-ahead, 3,167 observations for
3-year look-ahead, and 3,166 observations for 5-year look-ahead. For the 20% threshold, there are 2,561 observations for 1-year look-ahead, 2,560 observations for 3-year look-ahead, and 2,560 observations for 5-year look-ahead. 1-year, 3-year, and 5-year periods are overlapping periods. The bar chart shows the average returns for the 1-, 3-, and 5-year period following market declines. Data provided by Fama/French, available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. Short-term performance results should be considered in connection with longer-term performance results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Investing risks include loss of principal and fluctuating value.
There is no guarantee an investment strategy will be successful.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
I hope this post has succeeded in providing some comfort amidst the turmoil currently taking place in markets. I own the same type of investments that I use for my clients (I eat my own cooking, as the saying goes) and understand the wild ride investors are experiencing. To be clear, this post is not intended as investment advice or a recommendation; that would be impossible (and silly) to do on a blog. If obtaining individualized investment advice and financial planning is your goal, call me at (541) 639-4421 or email me at andy@vivifiplan.com to discuss your unique financial situation.
ViviFi Planning is a Bend, OR-based fee-only, fiduciary financial planning firm serving young professional families in Central Oregon and across the country. The author of this post, Andy Mardock, is a Certified Financial Planner® professional. He serves on the regional board of NAPFA and brings 10 years of personal financial planning experience to advising clients. To learn more, visit https://www.vivifiplan.com/about-us.
Past performance is no guarantee of future returns.