Tuesday, March 12, 2019
Conventional wisdom was defied, market timers missed out, gold underperformed, and those with a plan did just fine.
March 9, 2009
Ten years ago this week, the Wall Street Journal’s Money and Investing section printed the foreboding headline “How Low Can Stocks Go?”
The Dow Jones Industrial Average closed at 6,547, down nearly 54 percent from its October 2007 high. The S&P 500 fell to 676, down around 57 percent from its high. Banks had been partially nationalized. U.S. taxpayers owned nearly 80 percent of insurance giant AIG. Major automakers were on the verge of failing, and some had already received bailout funds from the government. The Federal Reserve lowered interest rates to zero, and Congress passed a $787 billion stimulus bill to prop up the economy.
The age-old battle between fear and greed was being decisively won by the fight or flight response, with thoughts of survival trumping all else. A managing partner at a hedge fund interviewed by The New York Times was advising well-off clients to buy shotguns to protect themselves against social unrest if the market fell any lower. It was a remarkable time in our history.
Thankfully, we know how this story ends. March 9, 2009 would turn out to be the market bottom. Banks would eventually untangle themselves from government involvement. U.S. automakers would survive. The Federal Reserve has raised interest rates nine times, signaling a stronger, stabilized economy. And the Dow Jones Industrial Average and S&P 500 have quadrupled in value.
As we reflect on the lessons learned from the global financial crisis and the Great Recession that followed, we find there are time-tested tenets of investing that not only held true for this past decade but have endured since the dawn of modern stock market investing.
1. The upside potential of equity returns is only earned by those willing to patiently bear the pain of down markets.
To paraphrase Theodore Roosevelt, “Nothing worth having comes easy.” In this case, the “thing worth having” is the long-term premium that investors have earned over the last century of investing in stocks.
Indeed, 5 percent pullbacks, 10 percent corrections, and 20 percent bear markets are all just a normal part of investing in a stock market that has historically trended upward over time.
The long-term return of U.S. equities has averaged 10 percent since 1926.
Since 1979, the average intra-year decline of the U.S. stock market has been approximately 14 percent. Even in years with positive returns, investors have experienced intra-year declines of 11 percent on average.
Why tolerate such madness? Because historically, investors are ultimately compensated for it. The long-term return of domestic equities has averaged 10 percent since 1926, compared to about 5 percent for 5-year Treasuries.
2. Market timing cannot be done in a way that consistently and reliably outperforms a buy, hold, and rebalance strategy.
The late Jack Bogle, who founded Vanguard and is credited with creating the first index mutual fund, stated:
“Sure, it’d be great to get out of stocks at the high and jump back in at the low. But in 55 years in the business, I not only have never met anybody who knew how to do it, I’ve never met anybody who had met anybody who knew how to do it.”
The biggest chink in the armor of market timing rests in the very nature of market moves. Missing only a handful of days can have an outsized impact on returns. The chart below illustrates the importance of remaining invested and staying disciplined through all market cycles.
3. Identify your near and intermediate-term cash flow needs and insulate them from the volatility of the stock market.
If you knew you were buying a car next year, would you set aside the necessary funds in an aggressive stock mutual fund? Similarly, if you’re retired and know you’ll be spending a predefined amount from your portfolio each year, should those dollars be invested in stocks or bonds?
Many investors allocate their portfolio based on their perceived tolerance for risk, but what’s more important is to measure one’s capacity for risk. By identifying both the timing and amounts of cash flows anticipated in the near to intermediate-term, the portfolio can be constructed in a way that protects cash flows from market volatility and provides peace of mind for the investor.
Many investors allocate their portfolio based on their perceived tolerance for risk, but what’s more important is to measure one’s capacity for risk.
As the graph below indicates, those who invested using this framework during 2008-2009 were able to rely on the safer portions (e.g., high-quality U.S. bonds) of their portfolio for cash flow needs, allowing the equity portion of their portfolios to fully recover. Those who didn’t protect their cash flows in safe assets may have been forced to sell equities at depressed prices, creating permanent and often unrecoverable losses.
4. Diversification works over time, but not necessarily all the time
Harry Markowitz, the economist and Nobel laureate, said that diversification is “the only free lunch in finance.” Markowitz was referring specifically to diversifying within an asset class—this idea that instead of owning just a handful of large-cap stocks (as an example), you should own hundreds of large-cap stocks. In doing so, your expected returns aren’t adversely affected, but the risk you take is reduced dramatically. Same return with less risk—a free lunch indeed.
In addition to diversifying within asset classes, it’s important to diversify among asset classes. The credit crisis of 2008-2009 demonstrated how important this is. While the U.S. stock market was down 37 percent in 2008, U.S. Treasury bonds were actually up 5.24 percent. Diversifying among asset classes with different risk/return characteristics allows one to build an “all weather” allocation that can provide for cash flow needs in any market environment.
5. Rebalancing allows you to systematically sell high and buy low
As Warren Buffet has advised, “Be greedy when others are fearful, and fearful when others are greedy.”
What are the practical implications of this advice for investors? Step one is setting an investment strategy that A) is designed around your goals and cash flow needs and B) is a strategy you can stick with in all market environments. Once you’ve established strategic targets to a variety of asset classes (both stocks and bonds), monitor those targets on a periodic basis, and as markets move, make incremental adjustments accordingly.
As markets pulled back heavily in 2008-2009, an investor’s allocation to bonds likely became overweight (given their relative outperformance), and equities became underweight (given their significant relative underperformance). By paring back on bonds (selling high) and reinvesting into equities (buying low), you were able to follow Buffet’s advice but do so within a disciplined framework based on long-term, goals-based allocation targets.
6. GDP growth expectations and investment return expectations are two very different things
Back in 2008-2009, many market commentators and analysts were pointing to emerging economies like China and India as the future growth engine of the global economy. Given these strong growth predictions, it was only logical that investors should allocate more dollars to these markets and expect higher investment returns.
Contrary to conventional wisdom, this wasn’t the case. As the data below illustrate, from March 2009 to January 2019, these emerging market countries significantly underperformed during this time period, even though their annualized economic growth (as measured by GDP) was significantly higher than their developed market counterparts.
7. Massive fiscal and monetary stimulus did not cause runaway inflation like many feared
As the credit crisis unfolded and the Great Recession wore on, the Federal Reserve brought short-term interest rates to zero and engaged in additional monetary stimulus known as quantitative easing. The federal government also injected liquidity into the economy through targeted stimulus spending (using borrowed funds to do so).
If anything, concerns about low inflation have supplanted worries about extreme inflation.
Many market commentators at the time and over the intervening years suggested that this unprecedented level of stimulus spending would lead to runaway inflation. Proponents of gold were touting the precious metal as the only safe refuge from the specter of soaring prices. But as indicated below, inflation has remained subdued, returns on gold have been underwhelming, and if anything, concerns about low inflation have supplanted worries about extreme inflation.
8. Rising interest rates don’t always signal negative bond and stock returns
In December of 2015, after economic growth had stabilized and short-term interest rates rested effectively at 0 percent, the Fed raised interest rates for the first time since June 2006, in what would be the first of nine interest rate hikes.
Had an investor been told that rates would increase nine times between December 2015 and today, surely one would expect flat or perhaps negative bond and potentially equity returns given the headwind of a rising interest rate environment. But as illustrated below, this was not the case. Both bond and equity returns have been decisively positive between December 2015 and January 2019.
What are we to learn from this? Conventional wisdom and market commentators are often at odds with the path that markets ultimately take, reminding us to stay centered in a long-term, goals-based approach and tune out the noise created by the financial press.
9. Control what can be controlled
It may be cliché, but whether the market is up, down, or sideways, focus on what you can control. History provides unequivocal evidence that markets are regularly and predictably volatile. Accept this fact, and then focus on areas that fall within your control:
- Manage Taxes: The sharp market declines a decade ago provided a golden opportunity to capture capital losses while maintaining exposure to the market. These booked losses serve as a tax asset in the future, providing an offset to future capital gains and up to $3,000 of ordinary income.
- Manage Savings Rates: If markets decline or don’t deliver the returns we all expect, we can partially offset the shortfall in returns by increasing savings rates. Although sometimes easier said than done, we ultimately can exert more control over savings rates than market returns.
- Manage Expenses: It goes without saying that saving more is easier when expenses are less (who knew?)! The first line item of your budget should be your savings target (401k, brokerage, education plans, etc.). The rest can be spent.
- Manage Investment Costs: Investing in broad assets classes has become very inexpensive. It rarely makes sense to pay over 1 percent for an active fund manager when a passively-managed asset class can be had for 80-90 percent less and likely provide better returns.
10. Patience and discipline ultimately win
As illustrated by the graph below, had you held a portfolio of 60 percent global equities and 40 percent intermediate-term bonds at the market peak in October 2007, it would have taken you just a hair over three years (38 months) to fully recover the losses you experienced and move back into positive territory. Given the magnitude of the 2008-2009 bear market, this is a remarkably short period of time. An all-stock portfolio took closer to 6 years (69 months) to recover from market highs.
In the end, a patient, disciplined, and diversified approach allows investors to withstand even the most brutal market environment and emerge relatively unscathed.
As we reflect on the last 10 years, we find that the 10 lessons learned are really just variations on core themes that have served investors well for the last 90+ years and will continue to serve them well in the decades to come. Although the credit crisis and Great Recession of 2007-2009 left an indelible mark on American households, politics, and economic policy, the enduring wisdom of successful investing was left fully intact, both before and after this challenging period in our history.
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