By |2022-01-18T13:56:37-05:00January 18th, 2021|Blog, Great Investors Series|

“The time to do lifeboat drills is not after the ship has struck an iceberg.”

– Nick Murray

In last month’s article, we focused on how “Unknown Unknowns” can be very tricky problems. This month, we ring in the New Year as we do every year, by re-publishing our annual reminder of the importance of avoiding surprise in our investing efforts.  We hope this article will help you to be prepared for the investing markets this year, and to avoid unpleasant surprises.

The Year That Was

Once in a great while, there comes a year in the economy and the markets that may serve as a tutorial: in effect, a master class in the principles of successful long-term, goal-focused investing. Two thousand twenty was just such a year.

On December 31, 2019, the Standard & Poor’s 500-Stock index closed at 3,230.78. This past New Year’s Eve, it closed at 3,756.07, some 16% higher. With reinvested dividends, the total return of the S&P 500 was about 18.4%.

From these bare facts, you might infer that the equity market had quite a good year, as indeed it did. However, what should be so phenomenally instructive to the long-term investor is how it got there. From a new all-time high on February 19 of 2020, the market reacted to the onset of the greatest public health crisis in a century by going down by roughly a third in five weeks. The Federal Reserve and Congress responded with massive intervention, the economy learned to work around the lockdown, and the result was that the S&P 500 regained its February high by mid-August.

The lifetime lesson here: At their most dramatic turning points, the economy can’t be forecast, and the market cannot be timed. Instead, having a long-term plan and sticking to it—acting as opposed to reacting, once again demonstrated its enduring value.

Two corollary lessons are also worth noting.  First, the velocity and trajectory of the equity market recovery essentially mirrored the violence of the February/March decline. And second, the market went into new high ground in midsummer, even as the pandemic and its economic devastations were still raging. Both outcomes were consistent with historical norms. “Waiting for the pullback” once a market recovery gets under way, or waiting for the economic picture to clear before investing, turned out to be formulas for significant underperformance, as is most often the case.

The American economy—and its leading companies—continued to demonstrate their fundamental resilience through the balance of the year, such that all three major stock indexes made multiple new highs. Even cash dividends appear on track to exceed those paid in 2019, which was the previous record year. Meanwhile, at least two vaccines were developed and approved in record time, and were going into distribution as the year ended. There seems to be good hope that the most vulnerable segments of the population could get the vaccines by spring, and that everyone who wants to be vaccinated can do so by the end of the year.

The second great lifetime lesson of this hugely educational year had to do with the presidential election cycle. To say that it was the most hyper-partisan in living memory wouldn’t adequately express it: adherents to both candidates were genuinely convinced that the other would, if elected/reelected, precipitate the end of American democracy. In the event, everyone who exited the market in anticipation of the election got thoroughly (and almost immediately) skunked. The enduring historical lesson: never get your politics mixed up with your investment policy.

The Year That Will Be

As we look ahead to 2021, there remains far more than enough uncertainty to go around. Is it possible that the economic recovery— and that of corporate earnings—have been largely discounted in soaring stock prices, particularly those of the largest growth companies? If so, might the coming year be a lackluster or even a somewhat declining year for the equity market, even as earnings surge?

Yes, of course it’s possible. Now, how do we—as long term, goal-focused investors—make investment policy out of that possibility? We don’t, because one can’t.

We have been assured by the Federal Reserve that it is prepared to hold interest rates near current levels until such time as the economy is functioning at something close to full capacity, which could be as long as two or three more years. For investors like us, this makes it difficult to see how we can pursue our long-term goals with fixed income investments. Equities, with their potential for long-term growth of capital—and especially their long-term growth of dividends—seem to us the more rational approach. We therefore tune out “volatility.” We act; we do not react. This was the most effective approach to the vicissitudes of 2020. We believe it always will be.

Having written all of this, although we do not expect a significant market decline this year, we will certainly not be surprised if one comes along.  We have learned well to avoid surprise in our investing efforts because Surprise is the Mother of Panic.

Surprise Is The Mother Of Panic

Great investors understand that all good investing requires control of our emotions in the face of uncertainty about the future.  There is an inverse relationship between the intensity of emotion that we may be experiencing at any given moment, and our ability to think and act rationally.  As our emotions crank up, our ability to act rationally begins to deteriorate.  Emotion is the enemy of sound investing policy.

This is particularly true of the emotion of fear.  When fear and panic set in to our minds, it is almost impossible to act rationally, and we are most susceptible to our worst and most regrettable investing mistakes.  For evidence of this, we need look no further than the millions of investors who liquidated their entire investment portfolios in the Fall of 2008, in hopes of avoiding the global financial meltdown they were terrified was coming.  Instead, as it turns out, that period may have provided investors with the greatest buying opportunity of a generation, as stock prices plummeted far below their real intrinsic value.

So how can we engineer our investment philosophy in a way that avoids the possibility of panic?

A good place to start is by understanding the nature of fear, and what makes us experience panic.  It is our belief that fear does not necessarily spring from the news of some economic or geopolitical “crisis”, a deadly virus, or even from the fact that the stock market is in decline.  Fear comes because we are surprised by these events – we are blindsided by a reality for which we were not prepared, and which causes us to lose our bearings.  This surprise causes us to lose our ability to make sense of the world around us, and so we become fearful, and uncertain about what will come next.

The best way to prevent fear and panic from sabotaging our investment program is thus to prevent ourselves from being surprised by events. In the simple wisdom of Nick Murray, we must do our lifeboat drills before the ship sails out of port and has any chance of striking an iceberg.

A New Year Resolution

January is the time of year we all make our resolutions for better living in the coming year.  As your investment advisors, we would recommend that you adopt a resolution to become a better investor by not allowing surprise to creep into your investing strategy this year.

The good news is that this resolution is relatively easy.  The best way to avoid surprise is to understand the possibility that our investments will experience volatility this year, as well as the severity of that possible volatility.  In other words, we must vigilantly school ourselves in the history of market behavior, so that we can constantly remind ourselves of the difference between volatility – the normal incidence of temporary decline – and risk (The historically nonexistent chance of permanent loss) in our portfolio strategy.

So as 2021 begins, let us resolve to understand the historical incidence of stock market corrections, as well as full blown bear markets.

Stock Market Corrections

We define a “Correction” in the stock market as a short term, relatively shallow (20% or less) decline in stock prices.  While a 10% to 20% decline in the market may not feel “shallow” while it is happening, we use that number as a way to differentiate from a “full blown bear market”, which takes prices down by 20% or more.

Fortunately, such corrections tend to be relatively brief, and usually last for only a month or two before they burn out and markets recover.  They are also very common – in fact, it is not uncommon to experience one or more such “corrections” during the course of a year, even when the stock market advances for the year.  It is very important to remember that such corrections happen all the time, and should be expected on average at least once a year.

By way of example, between 1980 and 2016, the average yearly “intra – year” decline in the S&P 500 exceeded 14%.  This means that, on average, the stock market declined by 14% at least once a year! However, during that period of 37 years, the stock market produced positive annual returns 28 times, and the index moved from 106 at the beginning of 1980 to 2250 by the end of 2016.

The lesson from this data is that market “corrections” are to be expected roughly once a year, even in bull markets, and even during years in which the stock market as a whole advances.

Bear Markets

We define a “Bear Market” in the stock market as a more extended, steep (20% or more) decline in stock prices.  Bear Markets are the common birthplace of full blown panic, and can test the emotions of even the most seasoned investors.  They are so scary, because they almost always occur during a time when the whole world is convinced of some geopolitical or economic catastrophe which is certain to tear down the fabric of our lives and economy as we know it.  Anyone who remembers what it felt like in the Fall of 2008, when it seemed that the world economy and capital markets were on the verge of collapse, knows this feeling of terror.

Bear Markets take a little longer to unfold, and usually last for a year or two before they burn out and markets start to recover.  In fact, the longest bear market since World War 2 came in 1946-1949, which took 36.5 months for the S&P 500 to travel from its peak to its trough. Fortunately, Bear Markets happen less frequently, and should be expected on average about every 5 years. In fact, the following is a recent history of Bear Markets in the post-war era through 2020.

Please note that we include here three episodes during which the S&P 500 declined by slightly less than 20 percent, simply because they felt like bear markets too. In addition, this chart does not include dividends in the S&P 500 return, which makes these bear markets appear worse than they really were. As a result, this chart brings the investor closer to the actual emotions experienced in real time when the bear actually strikes.

The takeaways from this chart are:

  • Although we are not predicting a bear market this year, we should be prepared that one can spring up any time. Bear markets happen all the time, about once every five years on average.
  • Historically, bear markets can cause temporary declines of 20% to 50% of equity capital.
  • During this period of 70 years, the stock market moved from 19 in May of 1946 to 3,732 by the end of 2020. The patient investor over this period returned over 190 times his or her money.

Although we do not necessarily expect a Bear Market in 2021, we must bear in mind that Bear Markets happen, and they can be painful.  However, historically they have always been temporary setbacks in the context of a long term uptrend.  Historically speaking, the declines are temporary, and the advances are permanent.

Empowered vs. Victimized

Before we leave the topic of volatility, it is also important to point out the most important observation which can be drawn from this data.  There is a transformative insight which can be drawn from truly understanding this data, and which can allow the investor to use market declines as opportunities to remain confident, while everyone else around us is screaming in terror and uncertainty.

When we understand, and come to peace with this data, we can begin to embrace equity volatility as a positive phenomenon, and in fact the reason for the premium return from equities.  The term “volatility” refers to the relatively large and unpredictable movements of the equity market, both above and below its permanent uptrend line.  Equities can, and frequently are, up over 20% one year and down 20% the next, and vice versa.  However if we believe that the long run returns of equities will approximate the past return, we begin to understand that these periods of downside volatility must likewise at some point be corrected by a period of upside volatility, greater than the long term average of roughly 10% per year.

The premium returns of equities are, therefore, the efficient market’s way of pricing in adequate compensation for tolerating such unpredictability.  Volatility is the reason equity investors are rewarded over time with premium returns, as long as we have the emotional strength to live through it.  For the wise and patient investor, it also provides a unique opportunity to accumulate more equities during a time when prices are temporarily depressed…kind of like a “Big Sale”.

Having A Plan

As we launch into the excitement of a new year It will be worth restating our overall principle of investment advice.  It is goal-focused and planning-driven, as sharply distinguished from an approach that is market-focused and current-events-driven. Long-term investment success comes from continuously acting on a plan. Investment failure proceeds from continually reacting to current events in the economy and the markets.

We are long-term equity investors, working steadily toward the achievement of our most cherished lifetime goals. We make no attempt to forecast the equity market; since we accept that the equity market cannot be consistently timed by us or anyone, we believe that the only way to be sure of

capturing the full premium return of equities is to ride out their frequent but ultimately temporary declines.  As the numbers in this article prove, at least historically, the permanent advance has triumphed over the temporary declines.

Our essential principles of goal-focused portfolio management remain unchanged. The only benchmark we should care about is the one that indicates whether we are on track to accomplish our financial goals, and Risk should be measured as the probability that we won’t achieve our goals. Investing should have the exclusive goal of minimizing that risk.

The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing.  They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.

Thank you, most sincerely, for being our clients. It is an honor and a pleasure to serve you.

CONTACT US TODAY

Don’t Panic!

Don’t let the market surprise you this year. Let us help you become a wise and patient investor.

CONTACT US TODAY
By |2022-01-18T13:56:37-05:00January 18th, 2021|Blog, Great Investors Series|

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