INSIGHTS

On November 05, 2018

AAM Viewpoints – Corrections Happen, But Stay the Course

I’d like to talk about the current correction and how we believe investors should consider proceeding. As of 10/26/2018 the S&P 500 is off -9.28% from its September 20 high, and most of its stocks are already in correction territory. About 75% of the index’s stocks are off at least 10% from their 52-week high, and 45% are off 20% or more. Twenty percent is the breakpoint to be considered in a bear market. Saying we are headed toward a bear market is a scary assumption, and one many have been calling for over the last nine and half years, but it’s still too early to say. Regardless of if we are heading toward a bear market or if this is just a common correction, staying invested is the best course of action, in our opinion.

Many market participants say they follow a buy & hold strategy, and that’s easy to state during a bull market, but far more difficult during a bear, especially if we see portfolio values fall 20, 30, or even 40%. But time and time again the data shows staying invested is the best course of action. If you look at Figure 1 below, you can see all 20-year holding periods between 1926 and 2011 were positive, along with most 10-year periods. The data shows investors benefit when investing with a long-term perspective, and the buy & hold strategy is an easy way to accomplish that. It has the potential to prevent us from getting overly emotional about the market and trapping ourselves in the wide variability of short-term returns.

Hindsight is 20/20

It’s true investors could substantially increase their portfolio returns by avoiding the market’s worst days, but – outside of a crystal ball – how would an investor accomplish such a feat? How would they time re-entry? Most likely they would do a poor job on both and miss out on a lot of return, and here’s why. The market tends to experience gut-wrenching negative days, but it’s also experiences delightfully positive days. And those delightfully positive days can be very concentrated and make up a large part of an investor’s total return. Looking at Figure 2, if an investor bought the S&P 500 on 12/30/1988 and held it until 10/23/2018, they would have a return of 1,779.6% (10.13% annualized), but if they missed out on the 10 best days of the market, their return changes to a mere 888.31% (7.60% annualized). The investor missed out on only 10 of the 7,513 trading days, and their total return was cut nearly in half.

Source: AAM, Bloomberg data | Past performance is not indicative of future results.

Since the investor missed out on the best days, I figured it would only be fair if I also assumed they missed out on the worst days. Looking at the same period as before, if an investor were to magically miss out on the 10 best and 10 worst performing days, their return would go from 1,779.96% to 1,909.40% (or 10.39% annualized). If we take it further and exclude the 30 best/worst days, the return goes up to 2,131.93% (or 10.80% annualized). This makes intuitive sense since an investor would need a 25% gain to make up for a 20% loss. As stated before, not participating in significant down days has a greater impact on an investor’s total return than participating in significant up days. But this scenario can’t be emulated in practice since we are using 20/20 hindsight. What we can do is structure our portfolio to minimize volatility. As we believe the data shows, a portfolio focused on having both low down-side and up-side capture has the potential to produce fantastic results.

Source: AAM, Bloomberg data | Past performance is not indicative of future results.

Overall, we believe the data shows that timing the market successfully is quite difficult due to returns often being concentrated in very short time frames. The buy & hold strategy is easy to implement and a great way to potentially avoid missing out on those returns. If this is coupled with a portfolio constructed to minimize volatility, it has the potential for even better returns, in our view. Corrections are bound to happen going forward as they are part of the normal market cycle, but no matter how bad they feel, staying invested is the best course of action, in our opinion.

CRN: 2018-1105-7010R