First, let’s get a better understanding of the actual historical impact of stock market downturns on investment savings. Despite the never-ending negative news headlines, the reality is that “bear” markets are relatively rare events.
Since 1960, there have been just 9 market declines of 20% or more (the minimum threshold that defines a “bear market”). Most of those declines ended quickly. In all, there were only 3 that lasted for more than twelve months: 1974, 2002, and 2008. So the actual incidence rate for a market decline lasting for more than a year over the last 55 years equals a 5.4% chance for any one year.
So, even while “bear” market downturns can cause a significant reduction in one’s stock investment values, most of the declines have not lasted very long. But unfortunately, the three that did have had a lasting psychological effect on many individuals. As a result, many investors panic during fleeting market declines, moving out of stocks into cash unnecessarily, causing them to miss rallies that drive long-term performance.
Since 1960, there have been 13 stock market declines of 10% or more (the minimum threshold that defines a “market correction”). Other than the 1974, 2002, 2008 “bear” markets, there have been only 3 other times in 1966, 1973, 2001 when they fell more than 10%.
This history shows that stock market investments rarely sustain a decline that will have a lasting impact on portfolio value. Despite this, the day-to-day market action including news reports by journalists (that are too often sensationally written in order to gain more viewers and advertising revenue) are always presented as being very significant for investors’ portfolios and their decisions. In reality, most of the time, all of it can be considered just normal background noise.
Because the daily information often lacks any meaningful value to base buying and selling decisions on, anyone (but a select few who have demonstrated the ability to make sense of it all over the long-term) trying to time investment moves based on it are bound to make so many unnecessary mistakes. Even though there may be some good calls, over the long-term, there will be too many market rallies missed to accomplish any lasting benefit. This makes it likely that investment returns will suffer.
The historical market data shows that most downturns do not hurt performance over the long-term. It is important to realize that attempts to make forward looking guesses about market downturns is a loser’s game. Because of the markets upward bias, one is likely to miss many more rallies than avoid market downturns.
Asset Allocation and Portfolio Re-balancing to Manage Risk
The best way to manage risk is through periodic re-balancing to keep an overall portfolio asset-allocation that maintains your desired stock market exposure level. Doing this eliminates the inherent risk in guessing the future direction of the market and provides a much better chance of getting consistent performance with less volatility. It will also eliminate unnecessary damage caused by poor market timing decisions concerning being altogether in or out of the stock market.
Historical returns have shown that a portfolio that allocates its investments among stocks, bond, and cash investments has less volatility and significantly smaller losses during market downturns. But most importantly, portfolios that are consistently allocated can expect a significant improvement in the time it takes to recover from market downturns.
When you calculate the losses of each of the 3 serious corrections experienced since 1960, portfolios that maintained a balance of 60% stock and 40% bonds never took more than 2 years to fully recover its highest value. This compares to the 6 year recovery time needed for being 100% invested in the stock market. The importance of having a quicker recovery hit home when, in 2008, many investors incurred losses that commonly ranged between 40% and 50%.
Periodic re-balancing also encourages the systematic capture of gains when asset values appreciate and provides greater investment opportunity when asset values fall. In addition to re-balancing on a regular quarterly or annual basis, additional re-balancing opportunities will arise and can be especially valuable when stocks fall or rise sharply.
Decent returns can also be gained from portfolio asset allocation and periodic re-balancing to maintain desired market exposures. As an example, since 1960, a portfolio balance of 60% stock and 40% bonds produced a median 8.8% return over 10-year periods.
Given the benefits, there is no reason not to take advantage of periodic re-balancing to maintain your desired asset allocation to manage your overall investment risk. Also, knowing that you are following a proven strategy will keep your investment program on course and help you worry less about the increasingly irrelevant day-to-day noise.
Greg Tinaglia
(last updated 06.06.2015)