One of my favorite quotes about investing is "surprise is the mother of panic." Want to lower your risk of panicking? Don't get surprised by market declines.
When markets are shaky, as they've been recently, your natural reaction can be to want to sell out and avoid the potential for further declines. It's natural. A lot of people say not to do this, others (often the ones selling market timing) say you should get out. None of these are helpful on their own. They’re just opinions. We should have a reason why we do what we do. We should invest based on evidence.
I looked at a diversified, all-stock asset class portfolio going back 30 years, to 1995. I wanted to see how often, despite earning about +10%/yr, this portfolio dropped at least -5%, -10%, -20%, and -30%, or more. I also wanted to see if, on average, a -5% loss tended to turn into -10% or -20%, etc.
If declines weren't that frequent, or when small declines did happen they regularly turned into more serious declines, it might make sense to worry about a portfolio downturn, or worry that a small drop will likely lead to a much bigger one. It might make sense to get out.
But if declines happened regularly, I shouldn't be surprised. If mild declines didn't reliably turn into major drops, I should conclude that getting out might cost more than it helps.
What does the evidence say?
✔️ On 19 different occasions, the all-stock asset class portfolio declined by at least -5%. Over 30 years, you should expect to see a minor blip almost every year (2 in 3, to be exact).
✔️ How often were the declines -10% or less? 8x, a little less than half. The other 11 turned into double-digit declines.
✔️ Of the 11 double-digit declines, how often did they turn into -20%+ bear markets? Just 4x. The other 7 were down only -10% to -19% before they recovered, and 15 of the 19 declines never reached -20%.
✔️ Of the 4 declines > -20%, how many became > -30%? Just 2. The other two were mild bear markets of -20% to -29%. 90% of declines were -30% or less.
✔️ Finally, how many of the two severe bear markets of -30%+ became losses of -40% or more? Just one. The 2007-2009 decline bottomed out at -58%.
This history doesn't inspire confidence in trying to time the market. Declines are common, but most of the time they're temporary drops of less than -20%. Then the recovery ensues, which lasts much longer, and is far more profitable, than the decline is costly. It's not to say that a -20% or -30% decline is impossible, but it is rare. But even these have seen swift recoveries that could not afford to be missed.
It's become a cliche at this point, but it's still true, being a successful long-term investor, earning the +10% return you expect from a diversified stock portfolio, requires that you ride out short-term declines. Because getting out AND THEN getting back in on time is incredibly tough to do.
Riding out the ups and downs isn't ideal, but it beats the alternative and remains the best chance you have to capture the returns you deserve.
____________________________
All-Stock Asset Class Portfolio = 21% DFA US High Profitability fund (DFA US Large Company fund prior to 7/2017), 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.
DISCLOSURE
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.