The Big Picture
“Math doesn’t lie, people do.”
The above is one of my favorites. It is not to say that people are generally liars. Only that a person may have a narrative they are pushing, an agenda, or some ulterior motive that may not be fully disclosed or transparent. Math on the other hand, is incapable of telling a lie by its very nature. Whenever possible, we like to support our narratives with math. Math simply cannot lie.
We’ve heard it all before…
“In the long term, the market always does well.”
“As long as you are diversified, you’ll be o.k.”
“If the market declines, that will be a great buying opportunity.”
On the surface these statements seem quite rational and to be fair they do have a level of truth to them. However, that is not really the issue. Whether or not over the long term the market does well is focusing on the wrong details. The devil, as they say, is in the details. Most investors, especially those saving for retirement, do not have nearly as long of a term as they may believe. There is a very specific timeline. Diversification, while critical, fails when you need it the most. And lastly; how does one take advantage of a “great buying opportunity” when they are already fully invested?
The issue here is we are missing the “rest of the story.“
Have a Plan and a Process!
From the Trenches
“And now for the rest of the story…” – Paul Harvey
Paul Harvey was a broadcaster famous for the above quote. When I was a child and got into trouble and maybe didn’t want to fully disclose my transgressions. My father, who was a fan of Harvey, would ask me for “the rest of the story.”
There are many dogma’s in investing and planning that have sprouted up over the years that I have found to be quite perilous, even deceiving. We hear all the pros but most of the time the cons get left out. The side of the story that is usually supporting an agenda is the only side told. Let me give you an example: There is a popular marketing piece that we see circulated frequently showing what happens if you miss the best days in the market. The declaration is that if you miss the best 10 days, best 20 days, et cetera, returns drop significantly with each successive number of days. The implication is simple; stay invested or risk missing out! What is completely left out of the argument is the flip-side of that coin.
“And now for the rest of the story.“ What happens when you miss the worst days? Would you be surprised to know that missing the worst days has a bigger impact? It does. Returns are improved by avoiding the worst days in the market more than by missing the best days (NAAIM).
Is there a proven strategy to allow you to capture the best days and miss the worst days of the market? There is not. Regardless of the quandary, the proposal is to stay invested at all times and you won’t miss those good days. Unfortunately you get the bad days as well. However, staying invested at all times is probably not the solution many are looking for. You need to be willing to accept some significant draw-downs if this is your approach. More importantly, mindlessly staying invested raises the probability of permanently altering your long term financial goals for the worse. This is not a prudent investment strategy. I know you have heard this from me before, so I will crack on to the point…
To the Math.
For planning purposes, we must use a long-term expected rate of growth on our investments as a base-line. For those more aggressive they may use 8%, more conservative, 6%. The idea is to come up with a projection that is comfortable and of reasonable basis. We then have the rule of compounding. Compounding these rates over time looks pretty good! If it was only that simple. If only that was what really happens. The unfortunate thing about the math of compounding is it doesn’t work out as expected when material losses are experienced. A material loss is one that may take several years to recover from and may derail planning goals. Or more simply, a bear market.
While smaller losses are recoverable over a fair amount of time, the greater the loss the more difficult the recovery. Furthermore, as the losses increase, the required return to get back to even grows at an exponential rate!
Bottom line: We all want returns and consistent growth of capital. However, there are times where the risks are simply not justifying the rewards. It is only after an event do investors realize this. When it is too late.
“If the words don’t add up it’s usually because truth wasn’t included in the equation.”
The average draw-down of a bear market is 38% (Zacks). A bear market is generally defined as a 20% decline. We have had 32 bear markets since 1900 (Zacks). A bear market occurs roughly once every 3.6 years (in recent decades, the occurrence has stretched to roughly 5-7 years). What do you do with this information? Nothing, nothing at all. We are constantly barraged with statistics on markets, and a good amount of this data is irrelevant! Here is what matters, if you are saving for retirement and experience an “average” bear market once every 5-7 years you are going to spend a lot of your time just getting back to even. While many argue that over time you will recover, and we would generally agree, this lost time may be detrimental to your planning. Especially the more frequently it occurs. A popular financial market commentator wrote a book all about trying to “get back to even”. While this is a strategy that you may employ, it is generally not a strategy we would endorse. At minimum, we recommend you understand the pros and cons of the investment strategy.
Here’s the rub!
There is no way to successfully predict when a bear market will arise. Many investment strategies do not even factor in the risk of a bear market. However, there are strategies that recognize that bear markets occur and focus on mitigating the pain that they cause. Relying on theory or an educated guess is not advisable. There are too many instances where this approach proved detrimental. Adding an investment process, the likelihood of increasing the probability of financial success is significant. While we can all hope that the markets will always rise, hope is not an investment process.