With the recent turmoil, clients are understandably nervous and wondering what to do.  Some see it as an opportunity while others consider getting out.

I am reminded of  a great presentation I recently watched from Larry Swedroe of Buckingham Asset Management, (and the author of 9 books including The Quest For Alpha),  which I will see if I can get posted onto the site, but in the meantime I would like to share with you the message because it is a good one.  (Note: this is all done from a U.S. perspective)

Let’s start by going back in time to March of 2009 at the very bottom of the market collapse.  At that time, things could not have looked darker, some of the largest companies in the world were collapsing, the global economy was screeching to a halt, the media was pounding us with the message that the world was coming to an end, and investors were running for the hills.

Now imagine that you have a crystal ball that has perfect foresight with respect to the economic climate (but you cannot see what the stock markets are going to do).  So you look into your crystal ball and this is what you see for the next two years or so:

  •  Unemployment continues to rise and remains in double digits for a couple years, then eases a bit but remains over 9% with anaemic job-growth
  •  The housing market continues to worsen and prices continue to fall throughout the period, with no end in sight
  •  140 banks fail in 2009, another 153 fail in 2010 and the failures continue unabated in 2011
  •  Oil more than doubles, gold surges and the dollar falls sharply
  •  There are a series of revolutions in the middle east starting with Egypt and Libya and spreading to Syria and beyond
  •  There is a major earthquake in Japan (the world’s 3rd largest economy) which seriously disrupts their economy and the supply chain, and includes the threat of a nuclear disaster
  •  The US federal deficit explodes out of control and the government shows a complete lack of ability to do anything constructive about it until they are on the very brink of default
  •  Several states and municipalities are on the verge of bankruptcy and/or default on their debt
  •  The PIGS crisis, with Portugal, Ireland, Greece and Spain all virtually bankrupt and on the verge of, or actually, defaulting on their debt

Remember, it’s March, 2009.  Now, knowing what you have just foreseen, what would you predict the stock markets would do over the next couple years?  Would you have the resolve to stay invested? I doubt anyone would have predicted that the markets would rally by more than 100% over that period.

But there is another aspect to this that is even more important for an investor.  For the market-timer, it is not just a question of getting out of the market, there is also the question of when to get back in.  And that, my friends, is the real problem.

The problem is that the market doesn’t go up in a nice steady fashion – most of the total return happens in short spurts and if you are not invested at those times you completely miss out.  For example in 2009, the S&P500 returned 26.5% (yes, one of the most frightening years in memory ended as a very good year for the markets).  But in January and February it dropped 18.2%.  It then climbed almost 55% for the remainder of the year.  However, almost all of that climb happened in March, April, July and November.  Most of the people that sold (that’s what causes a drop – people selling) were not in the markets in March and April and thus missed out on the majority of the gains.  And the only way an investor would have experienced the 26.5% return in 2009 was to stay invested throughout.

Then in 2010, the markets dropped again in May and June and there was talk of a double-dip and another possible recession.  The media wailed and investors again ran for the hills.  However things reversed in July.  Overall the markets returned 15% in 2010 but more than all of that came in September and December – if you weren’t in during those 2 months, well too bad (and based on monthly flows into and out of mutual funds, most people weren’t).

Let’s look back a little farther…

According to Swedroe, there have been at least 16 major financial crises since 1973.  There was the oil embargo, double-digit inflation, the S&L crisis, the Asian-contagion, Russian bankruptcy, the Long Term Capital Management fiasco, and of course 9-11, to name a few.  At least 16 in a 38 year period.  That’s one every two and a half years or so!  Apparently, they are a normal and regular occurrence.  But in each case, the world did not actually come to an end.  And in each case, the best thing to do was to remain invested.

And  In fact, despite all those crises, and several recessions, the market (the S&P500 in this case) returned 9.8% annually from 1973 through 2010.  And I would venture to guess that the only people who experienced a return even close to that would have been people that remained invested throughout (Mr. Buffett remained invested).

Now, in fairness, none of us can predict the future, and it is possible that it will in fact be different this time, but based on everything I have ever seen or learned, that seems unlikely.

To illustrate the unpredictability of returns, consider the following graph.  It shows annual returns fro the S&P500 for the last 85 years.  Despite the fact that the overall return through that period was just about 10%, there were only 5 years where the actual return was between 8 and 12%.  There were 32 years (including 2009) where the return was greater than 20% and if you want to get anywhere near a market return, you had better be invested for those years.  There were also 24 years where returns were negative, and in 6 of those years (including 2008) the return was below -20%.

Source: Dimensional Fund Advisors and Buckingham Asset Management.Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent results of actual trading. Information from sources deemed reliable, but its accuracy cannot be guaranteed. Performance is historical and does not guarantee future results.

To quote Wellington West from DFA, “the markets don’t go up in spite of the risk, they go up because of the risk”.  It is the volatility that warrants the higher return.

And it is what it is – so don’t let the dips get you down.  In fact, for those who are regular savers – weekly, monthly or whatever – you experience the magic of dollar-cost-averaging which ensures that you will not only achieve market returns, but you will better them.  And the more volatile the markets, the more you will beat them by.

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