A premier episode of short-term stock market volatility was experienced by investors with stock market holdings during the first quarter of 2016. The initial decline during the first quarter of 2016 was the steepest seen since 1926 when reliable data started being recorded. In the space of that time the stock market fell 10% in value. The speed and depth of the decline was understandably unsettling.
But, it becomes less so when one looks at it from a historical perspective. Such declines are not all that uncommon. In fact, the financial market data over the past century show that declines of 10% occur on average once every year.
The Psychology #1: Because the frequency of such declines is often overlooked or forgotten there is a tendency to assign more significance to them than is warranted.
Before going further let’s define 4 levels of declines:
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“Routine” declines between 5% and 10%: occur on average more than 2 per year.
“Correction” declines between 10% and 15%: occur on average 1 per year.
“Severe” declines between 15% and 20%: occur on average 1 time every 2 years.
“Bear Market” declines 20% or greater: occur on average 1 time every 3.5 years.
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Knowing how frequently we experience various levels should help to keep us from assigning more significance than is due to any particular investment market decline we may have just experienced or will experience sometime in the near future.
The Psychology #2: Investment Losses cause a much stronger emotional response than Investment Gains do.
One reason for this is that losses often become more noticeable and appear more noteworthy just because they happen less often than gains do. The historical stock market data show that gains are produced in 7 out of every 10 years vs. 3 losses for every 10 years.
Another more significant reason is found in everyone’s biological makeup. It is the naturally occurring, fear induced, “fight or flight” reaction in response to any dangerous circumstance that may potentially harm our own well-being. Since investment losses certainly could become great enough to cause life changing damage, it is natural to respond emotionally to it in the same way that we would for a serious immanent physical threat.
Certainly one would agree that a decline in one’s investment values that is no greater than 1% would not be considered large enough to worry about. Such a loss would be very unlikely to cause a “fight or flight” reaction for most people. But, as losses increase there is a level of loss that would certainly justify having some level of rational fear develop.
Of the 4 levels that we have defined above, it should only be experienced at levels that are above the “routine” 5% to 10% loss that occurs on average more than 2 times per year. If one begins to experience significant worry while losses still remain within this range, we would argue that such worry is really unnecessary if one really understands how much time it usually takes to recover from stock market losses.
Since 1965, the average time it takes to recover stock investment declines:
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“Routine” declines between 5% and 10%: recovery time average 74 days.
“Correction” declines between 10% and 15: recovery time average 112 days.
“Severe” declines between 15% and 20%: recovery time average 133 days.
“Bear Market” declines 20% or greater: recovery time average 993 days.
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We have seen over time that stock market values do eventually rise given enough time. This is fundamentally necessary for the survival of any society, such as ours, that is based on capitalism. Once one realizes the average amount of time it takes to recover from losses, it becomes apparent that most declines are fully recovered fairly quickly. Since 1965, declines other than "Bear Market" declines have been fully recovered in less than 19 weeks (on average).
When losses rise to 20% or more, the recovery times accelerate to levels where it takes much longer to recover causing too much potential additional future new gains to be missed. But even worse, the chance for continuing additional losses also increase. As seen below, the average ending level for a "Correction" loss is 18%, so many have also passed the 20% loss level.
Since 1965, the average total loss before the decline ends is shown below:
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“Routine” declines 5% or greater: average ending total loss 9%.
“Correction” declines 10% or greater: average ending total loss 18%.
“Severe” declines 15% or greater: average ending total loss 24%.
“Bear Market” declines 20% or greater: average ending total loss 39%.
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A Prudent Defensive Strategy to Protect Portfolio Values
Knowing the importance of limiting the amounts, duration times, and potential total ending losses that will be experienced over time, an investment strategy can be implemented that can reduce the chances of experiencing investment losses that are serious.
Looking at the statistics from past market declines that have become serious, it becomes clear that risk management objectives begin to outweigh return objectives when market index losses surpass the 10% "Correction" level. For many retirees, history has shown that taking action to reduce portfolio stock market exposure before losses exceed 10% helps to insure that the necessary portfolio values will be maintained so that long-term income requirements can remain adequately funded without unplanned reductions.
When a defensive portfolio protection strategy is implemented, it should also be understood and accepted that a reduction of stock market exposure will also correspondingly reduce the portfolio return opportunity in a subsequent market upturn. At the time that an ensuing upturn occurs, the defensively positioned portfolio will understandably lag the stock market to the extent and length of time that its exposure has been reduced. For example, if the stock exposure level has been reduced to 50%, then the following return participation level can be expected also to be around 50% of the stock market’s return.
Our Conclusion for Actively Managing Portfolio Risk Exposure:
When near and long-term value protection is also a portfolio management objective, the history of market declines (as seen again in the recent 2002 and 2008 market downturns) illustrate the importance of not overlooking implementation of an effective defensive strategy for portfolio protection.
Greg Tinaglia
Last Updated: 03/20/2016