After fives years of really great returns in the US stock market, many investors are getting concerned about the recent selloff we have experienced. Many markets are down more than 10% from their peak and the S&P 500 is off more than 5%. At times like these, it is important to revisit how this market downturn compares to prior corrections and if there are reasons to panic.
Goldman Sachs has a good chart they've put out on corrections over the last several years and the largest drawdowns we have seen throughout those years.
This chart, along with other research on the same topic, has both good news and bad news. First the good news: this is entirely normal- the stock market has corrections like this all the time. Even during the last five years when the market skyrocketed, each year experienced corrections as bad or worse than this one.
Now the bad news. On average, corrections in most years are much worse than this. In fact, JP Morgan found that the average intra-year "correction" in the S&P 500 since 1980 has been 14.7%. This is nearly three times the amount the market has dropped so far this year.
The takeaway is twofold. First, this is no time to panic. The correction we have seen is entirely normal. Second, you need to be prepared for much worse. We don't know if this correction will end shortly or go on for the foreseeable future, but history tells us that even if we reverse course and the market goes on to new highs from here, we need to expect losses from time to time.
Finally, I saved the best news for last. You don't need to predict the direction of the market to be successful. The same research from JP Morgan that found that the S&P has average intra-year corrections of 14.7% per year also found that 25 of the 33 years measured were positive. To be successful, you just need to have the fortitude to stick it out, no matter the market environment.
For those of you not following the investment industry closely, one of the highest profile mutual fund managers recently left the firm he co-founded (you could say he was forced out) to start at a new company. Bill Gross, dubbed the "Bond King" ran the PIMCO Total Return Fund, the largest bond fund in the world after disagreements with the Board of Directors at his parent company, a supposed autocratic leadership style, and trailing performance at his fund for the past several years. This is a classic example why we try to avoid "Star Managers". Let me explain our reasoning:
- Funds run by star managers are dependent on those managers- if you invest in a fund that has a high profile manager running it, you are really putting all your hopes in that manager being able to continue. What if he retires? What if he becomes disabled or dies? What if he gets caught in some sort of scandalous behavior? We don't like investment strategies that are dependent on one person or a small group of people.
- There is still no evidence star managers are skillful- studies and evidence confirm that past performance (the key metric of a star manager) has no predictive ability on future results. The data suggests that it is much more likely that star manager performance is attributable to luck.
- Star managers typically cost more- because star managers have great track records they tend to charge higher expenses than funds that have no star performer. For example, Bill Gross's flagship fund, the PIMCO Total Return fund has an expense ratio of 0.46% which is very competitive, but is still nearly 6 times more expensive than the Vanguard Total Bond Market Index Fund, a fund that has no star manager and just attempts to replicate an index.
- Star managers will underperform- every star manager will have some period of underperformance. Bill Gross experienced this the last few years. As an investor you have to determine whether or not that underperformance warrants a change or not. There are plenty of managers that have bad performance and stay bad until their fund merges or shuts down. Conversely, some star managers have small periods of underperformance before reversing course and outperforming again. As an investor you need to figure out which direction your fund is going and position accordingly. Unfortunately, there is no data that can help you determine what the right decision is.
Rather than focusing on funds run by "star managers" we prefer to focus on things under our control. We call it evidenced-based investing: investment strategies must be rooted in evidence that has been tested and found to be true. If you take this approach it is very difficult to choose funds that have star managers.
Do you own any individual stocks? If so, it would be beneficial to keep reading. JP Morgan is out with a very interesting piece about the difficulty of investing in individual stocks. The results are pretty astonishing and should make you think twice about committing any serious capital to this endeavor. Here are some of the results from their recent report spanning from 1980 until 2014:
Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value
The return on the median stock since its inception vs. an investment in the Russell 3000 Index was -54%.
Two-thirds of all stocks underperformed vs. the Russell 3000 Index
What does this tell us? It is really hard to pick stocks. These results show that even just picking a stock that is in the middle of the pack will most likely not get you the average returns you would experience by owning the who market. This is because a small group of stocks seem to drive the bulk of the returns of the market and a greater percentage (roughly 40%) have suffered permanent capital loss. Yes, you may get lucky and pick one of those winners, but the odds are definitely against you. It is a much better odds to diversify and own the entire market, while focusing on things that actually will generate positive results (minimizing costs, optimizing your allocation, reducing taxes, staying disciplined,etc.). It may not be as fun (or as wild of a ride) but the results will speak for themselves.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.