CapitalTime

Articles on investing and capital management, with a quantitative focus.

Handling Market Declines

2022-07-03

The markets have been uncooperative so far this year. As both stocks and bonds decline sharply, I've been reminding myself of a few things:

We can't predict what happens next

The financial media is full of personalities who make predictions about the future. Active fund managers try to predict things such as stocks and interest rates, often claiming that they can trade around changing market conditions. For example, they may recommend avoiding stocks while they wait for a larger decline.

In reality, nobody can accurately predict financial markets. This is one of the core principles of passive investing, and a concept that I first learned about from Harry Browne.

Since nobody can predict markets with any consistency, the best approach is to remain invested in one's portfolio.

If you would like a deeper dive into the myths of active management, I recommend watching this lecture from Aswath Damodaran of NYU starting at 13:39. He describes research as far back as 1968 which found that active management does not beat the market.

Investing isn't always fun

Rising markets are pleasant. People enjoy seeing their portfolios increase in value, and they feel wealthier as a result.

But markets fluctuate, and (obviously) don't always go up. For example, since 1986, global stocks have been positive in 73% of the years, and negative in 27% of the years. Although this has generally been an excellent period for stocks, a whopping 27% of the calendar years had negative returns!

Unfortunately, investing isn't always fun. This is just the nature of markets.

This is a long term game

Many people are focused on the current calendar year's returns. This is an extremely short time period which really doesn't matter in the big scheme of things.

I've been reminding myself that investing is a long term game. I try to focus on the compound annual growth rate (CAGR) over many years. One could even argue that there's not much point in looking at anything shorter than a 5 or 10 year CAGR.

Historical context can help

I think it can be helpful to study historical portfolio performance to get a sense of what to expect, or to see what is "normal".

Here's the historical performance of a global 60/40 balanced fund, which is a very popular asset allocation. This is just an example, and obviously one should look at their own particular portfolio.

The global balanced fund is currently down 16% this year. The "Drawdowns" tab at Portfolio Visualizer shows previous drawdowns back to 1987. Previous downturns were as bad as -20% to -34%, so an investor has to accept the possibility that the losses could become that severe.

The "Rolling Returns" show the annual returns for rolling periods, such as 3 years (36 months). Here we can see that 3 year rolling returns can easily be around 0%. An investor might see no returns over a 3 year period. It's happened before, and will probably happen again.

What we're currently seeing in the global 60/40 portfolio is normal. It's well within historical ranges.

— Jem Berkes