A Lesson in Market Returns

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In full disclosure: I'm a firm believer that financial markets provide a great platform for building wealth, stock prices in the markets are generally fair, and there are great models available to help interpret what's happening. These ideas are all supported by academic research, but Wall Street firms sometimes refute these concepts to help drive their own selfish sales interests.

The most common questions the last few weeks are:

  • When do you expect the next bad market?
  • How bad will it be?

THE FIRST PART OF MY RESPONSE is a reminder that your market expectations are only half of the story. Think back to March of 2009. We had just been through some of the worst equity returns in history. The general economic outlook could be described as hopeless. 

S&P Market Performance

S&P Market Performance

If you lived through this time period as an adult you can distinctly remember the uneasy feeling and the sense of despair that so many people had for months on end.

Things were so bad you may not have realized that the S&P 500, for example, hit its bottom in March of 2009 and started an upward climb. Now we can take a look at the data on how markets recover after a significant dip, including what happened after 2008, and feel encouraged.

MARKET RECOVERY [in total returns]*

How does S&P500 performance look for the 5 years immediately following each of these declines ? 

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*Portfolio is comprised of 36% S&P 500 Index, 24% MSCI EAFE Index (net dividends) and 40% Barclays Capital Gov’t/Credit Intermediate Bond Index.

This gets to the real lesson: market performance is not predictable based on expectations alone, no matter what data you might have on valuations or anything else of that nature. The markets began recovering in March 2009 because expectations were far worse than the reality of how bad things actually got. In other words, once investors saw that it wasn't as bad as expected, they started buying—increasing demand for stocks and driving prices up. Remember, economic forecasts at the time were abysmal. 

Markets will turn negative when reality shows us how near or far off our expectations were.

And they surely will. We just don't know when.

NOW FOR THE SECOND HALF OF MY RESPONSE. If you look at any historical returns line chart, it seems to tell a story of a slow and steady upward journey. What the data really indicates, however, is that positive returns tend to come in short spurts (single days) that are easy to miss if you get the bright idea to stay out of the market for any length of time. Look at this S&P 500 returns analysis for 1975 - 2015, and you'll see the damaging effects of missing the best days. Notice how only 5 days in that entire period contributed 1% ANNUALLY. That's unbelievable.

S&P500 Chart - 1970-2015.png

Would you sit out...

...if you knew missing the 5 best days between 1970-2015 would decrease your compound annual return more than 1%?

S&P500 Data - 1970-2015.png

Feeling icky about the market and want to sit out for a bit? Assuming you have global sector and geographic diversification—and a split between stocks and bonds that's well-tuned to your specific situation—then sitting out of the market is a terrible idea. I wouldn't want to be anywhere other than present in the markets for every day of returns if positive results are an important part of my financial plan. Taking the good with the bad is the lesson here. 

Anectodely, I've probably interacted with a dozen or so people in my experience who took serious time off from stock investments to wait out a troubling period in the markets. And ALL of them did so for more than 25 days. With that in mind, look at the data above and see how much of the S&P 500 performance you missed if you sat out for 25 days between 1975 and 2015. Was it really worth it?

SO, TO SUMMARIZE: Think markets are headed for disaster? I have two responses for you: 

  1. Market expectations alone aren't a worthwhile tool for predicting performance, no matter what data point you're using in your argument. Instead, what matters is how our expectations compare to reality. I don't think we're equipped to make that kind of comparison until after it happens.
  2. Market performance comes in such short blips (single days at a time) that my recommendation is to stay present in the markets at all times. Of course, that assumes you're using an appropriate allocation for your specific situation and investing for long-term goals. But trying to skip a bad market means you have to also know when to get back in before things get too good again. Otherwise, you're likely to miss the best few best days of returns.