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Timely Spotlight on the Market's Peaks and Valleys

Today’s post may be one of my favorites, not only for its direct message, but because of the story behind it. I happened to write a first draft of it on my flight back home from a BAM Advisor Study Group graciously hosted in Dimensional Fund Advisors' Austin headquarters. Re-inspired by the invigorating forum, I wrote about how to stay the course toward your personal financial goals whenever the markets might once again grow volatile. That Friday, February 5th, the markets did, indeed, grow volatile, Wow, I’m psychic!

Of course the truth is I’m no more prescient than the next guy. It was just dumb luck. Knowing that makes all the difference in the world – for myself, The Cogent Advisor, and the investors we are privileged to advise. Want to know why this understanding is so important to your own investment experience in this and every other market climate? Read on.

My Irish family likes to joke about how us Celts are never truly happy unless we believe calamity is just around the bend. The same can often be said about the investing public. It seems we’re never happy unless we’re sure that market misfortune is imminent and, as a corollary, we’d better trade right away to prepare for it. Every so often, we happen to get it right. But while markets routinely take dips, they ultimately rise almost three out of every four years.

In other words, odds are against you if you bet against the market’s long-term growth.

Still, the longer the equity markets were on their record-breaking tear since February 2016, the more energetically many individual investors and the popular press alike had whipped themselves into a frenzy trying to determine just where the peak of this run would be, and what to do once they neared it.

Then came that volatile week and, with it, the proverbial other-shoe drop. It may have felt especially startling because of the recent calm. As Wall Street Journal columnist Jason Zweig said, “[T]he pain of a market drop depends not merely on its size, but on its steepness relative to recent experience. A 5% drop back in late 2008 or early 2009 was almost routine; now it feels like a frightening deviation.”

What Next? A Behavior Check

While I too have my personal views on the state of the markets (I am a recovering CME trader after all), I have learned to keep my opinions in check. I have too many data points from past lessons learned to still believe that my hunches can consistently beat the market’s collective pricing powers. My own or anyone else’s emotional instincts are far more likely to take my investments on an inefficient, rollercoaster ride.

Instead, I have been an evidence-based investor since 2002, through enough mild-to-severe market highs and lows to test any investor’s mettle and discipline. I do find it so much easier now to resist any urges to try to time markets, under- or over-weight sectors or countries, or otherwise deviate from my disciplined investment plans.

Our Cogent Strategy 

My Cogent team and I aim to deliver a similar experience to our clients. We discuss with our clients (and anyone who will listen) that the greatest challenge to successful investing isn’t necessarily the academics; it’s keeping our unreliable selves in line. One way to manage both is by establishing a personalized investment plan, documented in a written Investment Policy Statement and implemented in portfolios guided by the tenets of evidence-based investing.

From first-hand knowledge and feedback we learn from our client families, this strict regimen is incredibly liberating. No longer do we have restless nights or stressful days festering over market heights or lamenting its lows. This frees us to focus on our prudent, goals-based planning. Our success still isn’t guaranteed; but an evidence-based investment method gives us the highest likelihood to achieve what is most dear to us.

Evidence-Based Insights on Market Volatility

We are realists, informed by market history replete with bears and bulls. The very reason we seek the risks of owning a small, personal slice of the world’s capital markets is to gather their expected returns over our investing horizon. But to do that, the evidence should be your guide. It informs us:

  • No one can consistently predict when, why or at what level market corrections will begin or end. (Recent volatility is a case in point!)
  • However deep or shallow a correction is, the market’s long-term trajectory has always been on the up and up (You can visit "Teachable Moment" Tony Isola’s handy index-card post for more stats on that.)
  • Patient investors can expect to be compensated in the long run for embracing market risk, but we must be prepared to stay the course through the periodic downturns. (If you won’t be able to do that – if you can’t stand the heat, or you’ll need certain assets for near-term expenses – the stock market may not be the best place for the dollars involved.)

More on Managing Market Volatility

At The Cogent Advisor, we see markets as an ally, not an adversary. Rather than try to “game” the ways markets are mistaken, we build on the ways they’re right – the ways they have typically compensated investors. We seek to relieve the stress and confusion of investing with clear, rational resolve.

And education. A little education can go a long way in unsettling markets. So let’s put any current volatility into proper context.

Prior to Feb. 2, the stock market had been through a remarkably tranquil period. Since that date, the U.S. stock market has experienced multiple days with drops of 2 percent or more in a short period of time. Here, though, we will focus on the long-term investing concepts you should keep in mind, as well as historical context for market moves of this magnitude.

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Short-Term Forecasting Market Movements

Markets are notoriously difficult to forecast over any horizon, and this difficulty is only amplified over shorter periods of time. Nevertheless, this won’t stop some market “professionals” from trying. You would be wise to ignore these forecasts in your own decision-making. Yes, markets can become extremely volatile, but that volatility might not continue and no one can reliably know whether stocks will move up or down from there. In fact, no one can even clearly know what caused the drops. Some commentary we have seen points to inflationary concerns while other pundits blame anxiety around the U.S. budgetary process. Still others believe the market is concerned the Federal Reserve may raise interest rates too quickly. Who’s to say which, if any, of those explanations are correct, much less what that implies going forward. What we do know, though, is that over the long term, you can expect to be rewarded for investing in a low-cost, diversified portfolio of stock funds.

The recent past shows us just how wrong consensus, short-term forecasts can be. Two recent examples are the post-financial-crisis prediction of higher interest rates and the expectation that the stock market would decline following the 2016 presidential election. Both predictions were clearly wrong, and investors who acted on them instead of focusing on the long-run evidence that markets tend to reward risk-taking were harmed.

A Plan for Incorporating Risk

One of the advantages investors have today compared to investors in the early part of the 20th century is that we now have decades worth of data to help us understand long-run returns and risks. A couple of our strategic alliances, Dimensional Fund Advisors and BAM Advisor Services, maintain extensive databases of the risk profiles associated with the portfolios that we recommend to clients. This data allows us to incorporate risk into the way we build their financial plans, meaning that outcomes like the market falling by 2, 3 or 4 percent over a handful of days already are reflected in our recommendation.

We are well aware that these events, however unpredictable, will eventually happen, and we therefore imbed this knowledge in the comprehensive planning process that results in each client's portfolio allocation.

Putting Market Risk in Historical Context

The following graph plots the historical annual return of the U.S. stock market in each year (in blue) from 1926 through 2017 and the largest intra-year decline (in light blue outline) that occurred in each of those years.

Annual Stock Market Returns and Intra-Year Declines

Graph shows many more years of positive returns than negativeThere are two primary takeaways from this graph. First, as we all know, the stock market goes up far more often than it goes down. Second, but possibly less well known, virtually every year includes a period of time where markets fell precipitously.

Historically, the world’s equity markets have regularly corrected themselves intra-year on their long-term upward paths. For example, since at least 1979, U.S. equity markets (as proxied by the S&P 500 Index) have averaged annual drawdowns approaching 14%. Despite substantial intra-year drops, calendar year returns were positive in 33 years out of the 39 from 1979 through 2017.

It's a Fools Game Trying to Predict Intra-Year Swings

Investors who try to predict or react to these intra-year swings are more likely to generate lost opportunities than expected gains. Witness a recent Wall Street Journal article, “As Dow Tops 25,000, Individual Investors Sit It Out.” Based on a poll of investors of various ages and income levels from across the U.S., the article’s authors point out the massive net public outflows from equities, even as the market had quadrupled from its lows over the last nine years.

Why the disconnect between available and earned returns during what could be described as among the strongest, longest, steadiest bull runs of the post-WWII era? Maybe it’s the lost decade of the 2000s that broke some investors’ faith in market returns. Or the skepticism many may feel about “the establishment.” Or the barrage of entertaining but empty palaver glutting the popular financial press, the sheer volume of which may mislead people into believing any of it matters to their investment decisions. Or all of the above.

Who really knows? Whatever the cause, the unfortunate effect is the billions if not trillions of dollars of opportunity cost incurred by far too many investors who have been sitting on the sidelines.

We can’t undo the past. But we can learn from it. Whether current volatility lingers or languishes, as you contemplate your next steps, remember these principles: build and adhere to a personalized plan that keeps you in the market, so you can capture its expected long-term growth. Ignore any “noise” tempting you to do otherwise. Focus instead on spending your time and energy on the people you cherish and the activities you love.