First Aid Kit for Volatile Markets

This post is meant to serve as an evergreen resource NOW, in the current markets, and for the next 5+ bear markets that the average 30+ year investor will encounter. Before we start, I just want to let the reader know that I put out new content weekly via my free and informative eNewsletter, including good educational content on behavioral investing and how you can combat your own personal investing biases. Subscribe here. I last did a significant update to this post in 2022, in the middle of a real “bear market”, which commonly is defined as a market draw down (from a previously recorded all time high) of more than 20%. Significant market declines were as common historically as they will be in the future; nothing has changed. You might be reading this during a raging bull market, or markets might already be down 25% again. Either way, hopefully this acts as a useful resource to get you through it with minimal error. In most cases we focus on the S&P 500, when it comes to market declines, as this index of 500 U.S. stocks is the one most actively talked about in the world. Yes, there’s a TSX Composite here in Canada (representing mostly banks and resource companies) and I do believe more attention should be placed on actual global stock indexes. Most of the time, you’ll find the volatility of stocks globally to be a bit less, however, U.S. stocks nowadays make up 70% of the global index anyway, so let’s keep things simple and keep fixating on the S&P 500.... This is normal The first step to dealing with volatile markets is to understand THIS IS NORMAL, and we’ve been here before. News media will make a big deal out of it, and will have you thinking otherwise. “Crashes” in the markets, or “Markets in Turmoil”, as one cable network likes to call them, are not an aberration; they’re a feature. Just how normal? This chart from Dimensional Funds shows “The Bumpy Road to the Market’s Long-term Average”, how annual calendar returns of U.S. equities varied immensely over the years from 1926 to 2023 (thank you Dimensional for updating the doc annually and keeping the URL the same!). During this time U.S. equities compounded at a very respectable and rewarding return of about 10% annually, but you’ll see in the chart that an actual calendar year return of within 2 percentage points of 10% only occurred six times in those 98 years. It should be noted that the 10% historical return of U.S. stocks is no indication of what their future return might be over any period. Future expected long term returns are significantly lower, and come with a lot of risk, which might even include no returns over a 10 year period. More on that later. Capital Group put together a nice resource entitled How to handle market declines wherein they report the frequency of market downturns over the 70 years from 1952 to 2021: 5% or greater declines happened three times per year on average. 10% or greater declines happened about once per year on average. 15% or greater declines happened around once every three years on average. 20% or greater declines happened around once every six years on average. Cap Group hasn’t updated these numbers since year end 2021, but it would be a simple and unsurprising routine to update them to incorporate up to the time I’m updating this post in August 2024: 5% declines continued on their regular pace: after the big 2022-2023 decline was fully recouped at the beginning of 2024, they happened again in April and August 2024. A 10% decline hasn’t happened since the early-2024 recouping, however we got down to -8.5% on August 5th, 2024, and by the time this publishes we might easily be in that territory again. And that would be utterly, profoundly, normal of the markets. A decline of just over 25% occurred starting almost days after the cut-off of Cap Group’s numbers above. It took a full 2 years, from early-Jan 2022 to early-Jan 2024 for the markets to make new all time highs. Based on the historical average of greater than 20% declines “every 6 years” that Cap Group found, you can kind of average it out to 3 times per 20 year period. In the last 20 years these were 2008-2009, 2020, 2022. When the market drops by more than 20%, this is defined as a “bear market”. Bear markets typically happen once or twice every decade, and when they happen, the average market decline ends up being around 30% before it hits the bottom and then once again resumes its long-term uptrend. No one will recognize the bottom when it happens We just don’t know. Usually, the actual market bottom will be when the news is at its absolute darkest, when you can’t think of anything further than from buying stocks, when people around you are capitulating and selling everything out of fear. You will question why you’re invested in stocks and you will want to avoid putting additional money into stocks. By the time the coast is clear and the bad news that’s driving the bear market abates, the bottom will be quite a ways in our rearview mirror. The only way that we can be sure that we participate in the full advance of a bull market (from the very beginning of it) is to be fully invested in the markets through every bear market. Seen another way, the only way we can be assured of attaining most or all of the market’s long term average growth rate is to not ever put ourselves in a position where we might be OUT of the market during its advance. The strongest returns historically occurred right after the markets hit bottom but well before the “coast is clear”. Think about the massive rally markets had from end of March to September 2020, or the month of November 2023, to cite two recent examples. Those periods weigh heavily in long term historical average returns, but for the investor who exited the markets and only started investing again in 2021 or 2024, their long term return is permanently impacted. 2020 included many of the worst days on the market of all time, within a bear market drop of more than 30% (over a very short time!). The S&P 500 finished that year up over 18%. The strongest months that year were April (up 12.68%) and November (up 10.75%). Both these months occurred after the worst months, March/February (down well over 20%), and September/October (down over 6% combined). Unless you could have perfectly timed your exit, prior to the Covid crash, missing out on April and November would have wiped out a pretty good year of returns. More recently, the strongest month (I think one of the strongest of all time) was November 2023. From about mid-October, when the markets bottomed, markets rallied massively. Anyone who got out of the markets any time in 2022 and 2023 (due to a litany of reasons) likely didn’t choose October 2023 as their re-entry point. Perhaps they only re-entered the markets in early-2024, after “the coast is clear”. Volatility works both ways Price volatility refers to how much the price of something fluctuates below and above its average. Volatility, in the form of occasional temporary declines in the markets, is the price of entry—our cost—of getting the risk premium of stock market returns. If there were no volatility in equity prices then investors would more readily buy them, pushing up their prices and reducing the expected returns for new investors. It would be too easy. Investing is supposed to be hard. Pessimism is more intellectually seductive than optimism Hearing that things are getting worse is more interesting than hearing that things are gradually getting better over time, but rather than taking the words off the page of the great financial writer, Morgan Housel, read his timeless blog post on pessimism from 2017. Further reading: Hans Rosling’s Factfulness, and of course Morgan Housel’s The Psychology of Money. Your brain isn’t always your friend Human evolution has fine-tuned our brains for survival, not for investing or economics. All of us suffer from behavioral investment biases and the first step to overcoming them is identifying them. 3 big ones that affect us during every bear market... Loss Aversion Give one monkey two cookies and give another one cookie. Then, take one of the cookies away from the first monkey. While the second one is happily munching away on his cookie, the first monkey is upset and feeling a sense of loss. This is totally normal, and we humans feel it too. A loss causes a “fight or flight” adrenaline reaction that is disproportionate compared to the pleasure of a gain. As early hunter-gatherers, this helped us avoid going hungry, but as investors this makes us feel a 10% loss much more than a 10% gain. The best way to avoid this bias is to avoid looking at your investments too often; once a year is enough! Action Bias Don’t just do something, stand there! Have you ever watched penalty kicks in soccer and seen a goalkeeper jump out of the way when the shooter kicks the ball straight down the middle? Just as the keeper feels his or her job is to do something to stop the ball, we’re all biased toward taking action, especially when the markets crash. Sometimes though the best action is no action at all; just stick with your long-term plan, rebalance if necessary, and carry on. If your strategy made sense 3 months ago, why should it change now? “We would all be better investors if we just made fewer decisions.” - the late, great, Nobel Prize-winning behavioral economist Daniel Kahneman Herd Instinct This is one to be aware of both during a market correction, and as a preventative measure before corrections happen. Don’t follow the herd into the same investments when they’re hot (ie: tech stocks, resource stocks, pot stocks, real estate, etc) because you’ll be buying them when they’re at their most expensive and riskiest. Whenever markets crash, among the headlines are reports of massive outflows from equity funds to bonds or money market. Even though history proves that the best time to buy equities is when the herd is stampeding out of them, we tend to follow the herd, and when we do, we follow the herd off a cliff. So, what can you do about it? Know that each and every time stock prices are going down, the enduring value of their underlying companies is going up. Market declines are always to be experienced as sales, and the very nature of sales is that they’re temporary. Coincidentally, sometimes they are named like sales, such as “Black Friday”. The lower stock prices go, the more value is to be had at those prices, and logically, the risk level of the investment is lower, and its return potential higher than it was when it had a higher price. If you can’t apply the same correct instinct to buying stocks as you would to buying groceries then you’ll fail over and over again as an investor. Staying fully invested during temporary market declines is the only way you can be sure of being invested for the entirety of a market’s advance. Over the long term, markets have advanced in price—with occasional interruptions—and the risk of missing the advances, which can also be sporadic and unexpected, is far greater than the opportunity of avoiding the declines. You can’t sell out of falling markets, wait, and then expect to hop back in when the “coast is clear”. Never, ever make long-term investment strategy decisions out of short-term disruptions in the markets. It goes for anything in life: don’t make important decisions while in a state of fear, or any time you’re being overwhelmed by emotions. Think of it like sailing a ship. You’ll occasionally hit a storm, and when you do, you just gotta ride it out. The time for planning your journey, or deciding how much risk you’ll take (whether or not you’ll even sail far from the coast) is while the waters are calm. If you accidentally took too much risk to begin with, re-assess your risk and objectives when waters have calmed, not in the midst of the storm. Turn off the news. There will always be talking heads on TV who are forever at the brink of panic and will object to every one of the above points. Your financial well-being is not their prerogative; they want you to tune in or click on their articles, that’s all. Ignore them all and stick to your plan. Seek help, contact me now, if you want to re-assess your investment strategy, get a second opinion, and start to lay the groundwork for your lifelong financial plan. Markus Muhs, CFP, CIM Senior Portfolio Manager Senior Financial Planner Feature image freely sourced from Pixabay. Above icons were sourced freely from Freepik,