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Stock Market Bumps are Normal

David Andrew
David Andrew
Posted 18.03.2021 in Investment Planning

Once in a while, there are years that serve as a master class in the principles of successful, long-term, goal-focused investing.

2020 was one of them. The year reinforced some timeless investment lessons for the stock market:

  • Dramatic market-moving events come out of nowhere
  • It will always feel “different this time” because the circumstances are different each time
  • Experts often get it wrong, and the media will report it as the end of economic life as we know it
  • Significant declines in stocks are common and temporary
  • Neither the decline nor the recovery can be consistently timed, nor can the economy be consistently forecasted
  • The equity market tends to recover long before the economic picture clears
  • The highest-probability strategy is, therefore, to ride out each crisis, or better yet, buy more shares when they are down (through rules-based rebalancing)
  • In other words, don’t sell into major market panics; if at all possible, buy into them

On average, the largest stock market globally, and one our clients have substantial exposure to – the U.S stock market (as measured by the S&P 500 Index) – has declined by about a third every five years or so since the end of WWII. But in those 75 years, the S&P Index has gone from about 15 points to 3,756. The lesson is that, at least historically, the declines have been temporary, and long-term progress has always reasserted itself.

While news outlets get very jittery about all-time market highs, they are by definition a normal and expected part of economic growth.[1]

[1] Source: The Investment Strategy That Makes Your Life Easier, by Ben Carlson 9 February 2021

Does anyone recall anything special about 2013-16 now to explain this? No, nothing special comes to mind. Markets reaching new highs is not a cause for alarm – you expect it over time.

Yet, your investment experience will inevitably be bumpy.

While the S&P 500’s long-term return has compounded at an average 10%, in only six of the past 95 years has its annual return been within two percentage points of 10% (i.e. between 8% and 12%).

Yearly returns have ranged as high as +54% and as low as -43%. Since 2013, the S&P 500 has experienced falls of -12%, -13%, -10%, -20% and -34%. Yet each time, the market has come charging back to new highs. Note, there have been 70 years of positive annual returns and only 25 negative years.

Investing is always hard, no matter the environment. It’s hard when stocks are falling because losing money is painful, and it always feels like stocks could fall further. And it’s hard when stocks are rising because you balance the FOMO that comes from watching others get richer than you.

Over longer periods of time, bumps in the road on the journey toward our goals tend to smooth out. As investment advisers and financial planners, we think in decades at a time, including retirement, which averages three decades. This chart below shows the history of 30-year retirements using the S&P 500’s compounded average annual return over those golden years:

For 30-year retirements beginning in 1926 through to 1991, the S&P 500 returned a compounded annual average of no less than 8.5% and as high as 13.7%, averaging 11.2% over those sixty-six 30-year periods.

This confirms that when you retire can matter, but the likelihood of a reasonable investment outcome is high.

Looking Ahead

Looking forward to 2021, a big question on the minds of many investors is, “Why do I own anything at all other than the five big tech stocks (being Amazon, Facebook, Apple, Netflix and Google) which have done so much better than the S&P 500?”

These five stocks alone have also dampened the value premium over the past decade, leading some to wonder if the value premium is no more?

The problem with this thinking is it assumes past out-performance will continue.

This is usually based on a good story about the company. Still, the entire marketplace knows that same information, so it is already baked into the high price of the company at any given point. This thinking is also usually based on a speculation that what has been hot will continue to be hot, what behavioural economists call “recency bias.”

History is not on the side of investing in just the big-name companies. As this illustration below shows, the largest companies change significantly and unpredictably from decade to decade. Half of the current big ten companies are new (and therefore relatively unproven) club members.

Change in the 10 Largest Stocks at the Start of Each Decade | Source: Dimensional Fund Advisors

As the chart above shows, yesterday’s market leaders are today’s has-beens, so it follows that today’s market leaders will likely be tomorrow’s has-beens.

There is no way to construct a reliable investment plan from this chart, whether for a lifetime investor or just a 30-year retirement.

By contrast, the predictability illustrated in the first chart is something we can create a plan around with a high likelihood of success. Acting on that plan (instead of reacting to markets/events/news) through all the fears and fads of retirement or an investing lifetime helps us avoid sudden emotional and costly decisions.

So, let 2021 be the year we take three deep breaths, reassess where we are at, rediscover our most important goals, and update our financial and investment plan to align with our deepest values.

 

This article has been reproduced by consent of Abacus Wealth, our partner firm and a member of the Global Association of Independent Advisors.

David Andrew
David Andrew
David Andrew
Founder and CEO of Capital Partners, and author of Wealth with Purpose, David firmly believes that sound, objective financial advice can transform peoples’ lives and wellbeing. Find out more about how our evidence-based approach to wealth planning, investment management, legacy planning and insurance distinguishes our award-winning team, our results and our clients’ lives.

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