Since 2012, the stock market has demonstrated below average volatility and positive returns, potentially lulling investors into a false sense of complacency. It is human nature to extrapolate recent market performance into the future, so when the market has been tranquil, we expect it to continue in the same way. But could this be the calm before the storm? Academic research has shown that market volatility is not a reliable predictor of future returns. Nevertheless, we should not be caught off guard by the next market downturn, whenever that might occur.
So am I predicting a market downturn? Actually yes, I am reasonably certain that the stock market will have a substantial downturn at some point in the future, because that’s what markets do from time to time. Although I do not know when this will occur, I have some recommendations for how to prepare for the next significant market decline.
The first step is to have an appropriate asset allocation based on your risk preferences and investment time horizon. Stocks have a higher expected return than bonds, but their returns are also more volatile. By including a suitable percentage of bonds in your portfolio, you can dampen the volatility of your returns and help mitigate the effects of a market downturn.
The other factor that can help prepare you for a future market downturn is the knowledge that a disciplined long-term buy and hold strategy has helped investors weather the storm in the past. For example, the last global stock market correction occurred in 2011, when there was a 22.1% market decline. Let’s assume that you had a $100,000 stock portfolio at the 2011 market peak. Your portfolio would have fallen to $77,900 in the ensuing market decline. At this point, you might have been tempted to bail out to protect what assets you had left, but that would have been a mistake. If you simply held onto your assets, the portfolio would have grown to $137,000 by 2016. A more conservative portfolio of 60% stocks and 40% bonds would have fallen to $87,000 during the market decline and rebounded to $125,000 in 2016. (1)
The resolve of even the hardiest investor was tested during the market crash of 2007-09. This was the worst stock market disaster since the Great Depression with a 58.4% drop in global equity prices between October 2007 and February 2009. But once again, if you stuck with your asset allocation strategy and remained fully invested, your portfolio would have bounced back during the ensuing five years. A 100% equity portfolio would have dropped to $41,600 at the market bottom and recovered to $100,000 five years later, while the more conservative 60/40 portfolio would have dropped to $62,000 at the market low and rebounded to $110,000 in five years. By year-end 2016, the 100% stock portfolio would have grown to $170,800 and the 60/40 portfolio would have been worth $140,400, representing a pretty good recovery from the second worst stock market crash in the past 100 years.
So please enjoy the calm markets while they last. When market volatility spikes up at some future date, as it inevitably will, you can gain some comfort from the fact that you were expecting it and have an appropriate asset allocation and a disciplined approach that should see you through in good shape.
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
(1) Steiman B. “Complacency and Calm Markets” (Northern Exposure, Dimensional Fund Advisors, June 2017).