The Illusion of Normality
To have a successful long-term investment experience, it is essential every investor understands what the journey ahead will look and feel like.
For anything to go through an ‘abnormal’ phase, it must also have a ‘normal’ one. So, what does a ‘normal’ market look like?
Ask a farmer about average rainfall figures and he’s likely to look at you sceptically. Knowing how actual rainfall varies from year to year, farmers will carefully manage their crops and irrigation. It’s a lesson many investors could learn as well.
Whilst the events of 2020 haven’t been seen for a century, the reaction of financial markets has been quite normal for an investor. From February to March there was great uncertainty, and financial markets reacted accordingly with stock prices falling. A few months later there was a greater appreciation for how COVID-19 would impact us all, and markets rebounded. Recently the S&P 500 index in the U.S briefly closed higher that where it started 2020.
Consider that since the S&P 500 officially became constituted of 500 stocks in 1957, it’s average annual return has been a little over 8%. During those 63 years, the index has returned between 7% and 9% on only four occasions. It has more commonly produced a return of between 19% and 21%, which has happened five times.
As we noted in a recent article, investment returns are not normally distributed: https://www.stewartpartners.com.au/insights/2020/5/7/lessons-from-covid-19-for-investors
What characterises the stock market is unpredictability. It is perfectly ‘normal’ for the stock market to react to news we’ve never experienced before and is largely unexpected.
Ironically, this unpredictability is cause for optimism rather than fear. It is the risk any investor must take when investing in stocks. But it is a risk that has consistently been rewarded.
As Elroy Dimson, Professor of Finance at Cambridge Judge Business School points out, the stock market has persistently out-performed bonds and cash in countries all over the world over more than 100 years.
The graph below documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the Australian market. The data shows that, while positive performance is never assured, investors’ odds improve over longer time horizons.
Frequency of Positive Returns in the S&P/ASX 300 Index (Total Return) - Overlapping Periods: 1980-2018
This is not, however, what an ordinary investor back at the turn of the last century might have expected.
“Our view was that back in 1900 only real optimists would have poured their money into industrial and commercial common stocks,” says Dimson. “Many risk-averse investors would have played safe with government securities.”
Is volatility a time to pick stocks?
Each day there are almost $700 Billion of stock trades across the world. Without doubt, a lot of information and expectations about the future are being factored into the prices in those trades. Remember – for every seller there must be a buyer.
Most explanations of recent market behaviour reflect hindsight bias detailing what everyone now knows. It is rare to hear someone asked a question about a market move and not give a detailed after-the-fact explanation. Few are willing to admit that they really don’t know or that many market moves are simply random.
It is also common to hear a stockbroker say a stock picking approach is best adopted when markets are emerging from a stressed environment, as it’s easier to pick the undervalued stocks. Their value proposition is to make 12-month forecasts and then trade clients into the next ‘big thing’. There are many research papers that refute this approach, but my favourite is by Matt Walcoff and Lynn Thomasson[i].
Working for Bloomberg, they analysed all U.S broker recommendations for stocks included in the S&P 500 Index for the period March 2009 (which was the low point for markets during the GFC) to January 2011. The report found:
Stocks with the most broker Buy recommendations rose by 73% on average during the period
S&P 500 Index rose by 88% during the period
Stocks with the fewest broker Buy recommendations rose by 165% on average during the period
An investor would have made 53% more buying the stocks the brokers said to stay away from.
Conclusion
While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience.
How does Stewart Partners help clients endure the ups and downs? The answers include:
Ensuring you understand how markets work
Ensure the percentage of your portfolio exposed to the stockmarket is appropriate given your personal risk tolerance, risk capacity and investment goals
Construct well diversified portfolios to ensure you don’t miss out on holding those few stocks which drive the market return each year, as discussed in a recent article: https://www.stewartpartners.com.au/insights/2020/6/3/the-perils-of-owning-individual-stocks-more-losers-than-winners
Act as a coach to keep you disciplined and ensure every decision you make is aligned with what is most important to you and your long-term goals
Author: Rick Walker
With thanks to: Patrick Cairns, “Is there such a thing as a normal stockmarket?”
[i] Equity Analysts Prove Hazardous to Returns as Contrarian Stocks Rise 165%’, Matt Walcoff and Lynn Thomasson, Bloomberg, 10 January 2011.