“More money has been lost by investors waiting for corrections, or seeking to anticipate them, than in the same corrections” Peter Lynch
I recently came across this statement from one of the market gurus and it made me think about it. As I have already talked on different occasions, the widespread rally of the stock market after the great crisis, which has already turned ten years, has generated much anxiety among investors.
Every other day apocalyptic predictions appear in the headlines anticipating an inevitable adjustment, and although experience has taught us that markets do behave in a cyclical way, determining exactly when they will see an adjustment has proven to be a task bordering on the impossible, and very expensive.
What do I mean by expensive?
I have already commented on the various strategies that an investor could have followed throughout the Financial Crisis experienced in 2008, but let’s recap.
Considering the previous maximum seen in October 2007 (14,167 points), an investor who remained stoic without leaving the market, nor contributing, would have accumulated a 66.2 percent gain as of November 7, 2017, equivalent to a compound annual return of 5.17%.
A bear market, by definition, occurs when it posts a 20 percent fall against its maximum value of the previous year. If an investor had reacted negatively to an adjustment of these dimensions, and decided to sell its positions at the end of June 2008, he would have experienced an effective loss of 20.4 percent.
Surely during the rest of 2008 and 2009 this investor could have considered himself as a genius, he was able to avoid greater losses; however, the main question is when would it be the best time to enter again?
If this investor stayed out of the market until the market recovered its previous maximum, it would have entered until March 2013, and from that point to date the market has advanced 65.6 percent. Doing arithmetic, $100 in October 2007, became $79.6 the day he decided to leave the market (with a 20.4% draw down), and these $79.6 invested in March 2013 today would be worth roughly $133. In contrast, the investor who did nothing and remained calm would currently hold $166.23, plus dividends that could have been received in the period of absence from 2008 to 2013.
This case, despite being not so flattering, points to someone who was eventually willing to return to the market, even above the levels at which he left.
Now, investors who have patiently waited on the sidelines for another adjustment larger than 20 percent, have already missed on quite attractive returns. From the highest point of 2011, 2012, 2013, 2014, 2015 and 2016, respectively, the market has posted effective returns of 83.3, 73.3, 45.9, 30.5, 28.6 and 18.2 percent. In annualized terms, these returns are equivalent to: 9.7, 11.3, 10.1, 9.7, 10.7 and 21.4 percent. These are real opportunity costs incurred, even when buying at the highest moment of these last six years.
In a study of the annual returns of the Dow Jones of the last 100 years we see that the average yield has been 7.8 percent, with a standard deviation of 20 percent (risk). Now, assuming normality in the distribution, we can assume that 95.5% of the observations would fall between -2 and +2 standard deviations, or yields between -32 percent and +48 percent.
How many times have we witnessed annual returns higher than 48 percent?
In a sample with almost 25,000 daily observations we saw 480 occasions (1.9%) with one-year returns greater than 48%. Now, the opposite case, with falls larger than 48%, were witnessed only 229 times (0.9%), that is, the advances were twice more frequent. How many times has the market fallen more than 32 percent? In the same sample, there were 820 (3.3%) corrections for 2,367 (9.5%) advances with a magnitude of 32 percent or more, hence the advances surpassed the falls by a factor of almost 3 times.
While there are tail events, or extreme returns with little recurrence, these have been tilted to the positive side. We must remember that in the long term the market has proven to be a useful tool for generating wealth, and time has been its best ally.
Although it would be unfortunate if a market adjustment were to occur soon, it would be worth bearing in mind what the evidence has shown us, and avoid succumbing to panic.