The benefit of almost three decades working as a financial advisor is that I’ve gained a lot of experience. I’ve worked with clients during some of the scariest times to invest in the last century. And even though we never repeat the past, I think there are a handful of important lessons we can learn from these experiences to better prepare us for the future.
From Dot-Com to Dot-Bomb
Very few people today remember the roaring 1990s or the multi-year stock downturn that began in early 2000. This is unfortunate, because it’s the closest comparison we have to today’s market.
From 1995 through March 2000, the technology-dominated NASDAQ Index gained +41% per year, while the technology-heavy S&P 500 Index gained +27.6%. What was it like? Every stock you picked went up. Index funds made money every year. And stock returns were so high that no one even noticed that their actively-managed funds weren’t keeping up; few complained about “only” earning +25% or +26%.
However, in April 2000, the bottom fell out of the stock market. Technology stocks, the NASDAQ, and the S&P 500 Index crashed. 9/11 didn’t help matters in 2001, and a recession in 2002 led to almost three consecutive years of stock declines. By September 2002, the S&P 500 Index had dropped by 44% and the NASDAQ by a whopping 74%! I can’t describe the amount of grief this caused to people who had bet big and concentrated heavily in technology and large cap growth stocks, which was almost everyone.
The early 2000-2002 decline didn’t have to be so painful for investors. If they had diversified their stock portfolios, including not just US large growth stocks, but also US and international large and small value stocks, they could have saved themselves much of the pain.
From April 2000 through September 2002, the DFA US Small Value Fund gained +4.9%! On the foreign side, the DFA International Small Value Fund only lost -4.3%. A globally-diversified, all-stock asset class portfolio* that included the S&P 500 as well as US and international large and small value stocks only dropped -14.3%, about 30% better than the S&P 500. This shallow decline would have been much easier for an investor to ride out.
The all-stock asset class mix also recovered more quickly; after a strong 2003, the diversified stock mix rose by +8% per year from April 2000 through 2003, gaining a total of +33.6%. The S&P 500 Index remained underwater, down 21.5% cumulatively.
However, few investors owned value stocks, especially those in international markets. Why? These asset classes all underperformed the S&P 500 in the 1990s. And almost everyone invests with recency bias—they make decisions based primarily on what’s happened in the recent past. Instead of chasing what’s working, we are better off ignoring investment fads and trends and making investment decisions according to what has worked over the long run. Knowledge of market history is an investor’s secret weapon that few have.
The Great Depression 2.0
After five years of above-average returns from late 2002 through 2007, the S&P 500 Index dropped -51% between November 2007 and February 2009. Talk about scary. The 2007-2009 period saw the worst decline for stocks in 80 years, since the 1929 Great Depression.
Investors who had expected small cap, value, and international stocks to bail them out, as they did from 2000 to 2002, were disappointed. All stock asset classes declined by between 50% and 60%. Diversified investors got a dose of reality. Stock diversification doesn’t save you in every downturn.
Sometimes, the only asset class that holds up is the one with the lowest expected returns: short-term, high-quality bonds. Over the 2007-2009 period, the DFA Five-Year Global Bond Fund returned +4.5%. This gain wasn’t enough to offset the massive stock declines, of course, but for retired investors, primarily, it provided an asset they could sell for income while they waited for stocks to recover. More risk-averse investors appreciated the stability of short-term bonds and benefited from the rebalancing opportunity they provided. Selling shares of appreciated short-term bonds in late 2008 and early 2009 to buy deeply depressed stocks paid off handsomely over the next five years as the global all-stock asset class mix averaged +25.6% per year from March 2009 through February 2014, more than recovering the temporary losses.
One of the things I still think about after the 2008 experience is whether clients are in the “right” mix of stocks and bonds. During up markets, holding short-term bonds can seem like driving with the parking brake on. For pre-retirees, it might be. But for those in retirement living off their portfolios—spending 4% to 5% of their principal annually—having an allocation to short-term bonds can give them the confidence to avoid bailing out of their stock allocations at temporary lows. A balanced stock and bond portfolio—for example, 75% in stocks and 25% in short-term bonds—will inevitably earn less than an all-stock mix, but if it (along with my advice) helps you to stay the course in bad times, the return penalty is worth it.
You Can’t Predict a Black Swan
Most investors today can still recall the market panic in early 2020, stemming from COVID-19 and the extraordinary political response. However, you might have forgotten just how scary it was initially. The stock market dropped by 34% in just 33 days, a full-fledged panic. What set this episode apart wasn’t just the severity of the decline in such a short period, but that the panic seemed worse for each of us personally. Money ceases to matter when your health and your life might be in jeopardy.
2020 reminded me that scary times can come from literally anywhere, and they are usually completely unpredictable. What’s called a Black Swan. Trying to forecast when the next 20% or 30% market decline will occur, and just how much it will fall before recovering, is nearly impossible. I keep issues of The Wall Street Journal from February 2020 to remind myself that just days before the pandemic hit and our economy was locked down, there was almost no sign of impending doom. The things we were worried about in early 2020, according to the headlines, were completely different from what actually took us down.
Ultimately, I came away from the COVID-19 collapse with a greater appreciation for how quickly the stock and bond markets incorporate news and information. Every day, we were learning more and more about Covid, and the stock market was reacting accordingly and appropriately. At first, it was nothing but bad news, and the question was, “How much worse can this get?” You’d expect prices to fall to reflect the rampant fear (who would be willing to pay all-time high prices at a time of maximum pessimism?), sometimes by as much as -10% in a day. Extraordinary times always lead to extraordinary market movements.
But stock prices bounced back just as quickly and, surprisingly, not on the confirmation of good news, but on the mere speculation of it. We were only a few weeks into the lockdown, and months before the Covid vaccine rollout, when the stock market started to recover. The worst month for stocks in the previous quarter century, the 30 days ending March 23rd, was immediately followed by the best month ending April 23rd. Against all odds, 2020 turned out to be a modestly positive year for the stock market.
Financial survival during the Covid collapse required something more than knowledge or a deep understanding of the situation. It required faith and trust in the resiliency of our society and economy. No one had any idea how things would ultimately work out, or if they would. All we knew was that there had been many unique periods of extreme difficulty in the past—World Wars, hyperinflation, assassinations, and terrorist attacks, to name a few. And our economy and the stock market always managed to recover. No one knew how things would work out those times, either. It’s something to remember and lean on when everything else feels so uncertain.
Facing Your Fears
Unfortunately, there will be more scary times ahead. That’s the only thing I can guarantee. It’s part of the roller coaster of long-term investing. But the declines don’t have to have a lasting impact on you or your wealth.
If your portfolio is well-diversified across core asset classes—US and foreign stocks, large and small, growth and value companies, and possibly some short-term bonds as well—you’re not overexposed to any one area that could go from boom to bust or fail to perform. Keeping all your eggs in one basket is the surest way to financial devastation.
If you tune out the noise of short-term returns and instead make decisions and base your expectations on long-term market history, you’re less likely to make an untimely and unprofitable move. You’re more likely to stick to your allocation and have the courage to rebalance it back to target—selling some of the best performers to buy the laggards—when everyone else seems to be doing the opposite.
And finally, if you can keep your faith in the eventuality of an improving economy and society, naturally reflected in higher stock prices, you won’t worry about your money all the time. You won’t panic in the face of temporarily losing -30% in a few weeks or -50% or -60% over a year or two; you’ll remember that stocks behave like a rubber band—the more they get pulled back (go down), the faster they snap back (go up). You won’t feel the need to predict when the next crisis will end; you’ll have the confidence that it will.
We’ll always live with scary times and scary markets. But if you can learn from the lessons of the past, put the principles I’ve discussed into practice, and avoid making the all-too-common mistakes I’ve described, you’ll survive unscathed.
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Global All-Stock Asset Class Mix = 21% S&P 500 Index, 21% DFA US Large Value Fund, 28% DFA US Small Value Fund, 18% DFA Int'l Value Fund, 12% DFA Int'l Small Value Fund, rebalanced annually.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. Indexes and mutual funds shown are for illustrative purposes only and may not be the only or any of the funds that Servo clients hold. Servo was not managing client portfolios over the entirety of the periods shown. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.