The frequency of five per cent market drops
By ATB Investment Management Inc. 18 March 2020 5 min read
Investment-related headlines have been fairly dark these days with much talk about volatility and losses.
As of March 16th, 2020, we’ve already experienced one monthly drawdown event of 5 per cent or more, which occurred in February, and we will likely experience more drawdowns in the coming weeks and months. A drawdown is defined as “a peak-to-trough decline during a specific period for an investment, trading account, or fund.”
While the headlines rightfully create fear and anxiety for most investors, it’s important to remember that they are an inevitable part of the investment journey. Unless your individual or family goals have changed, there is a reason advisors recommend not deviating from your long-term plan. Your advisor helps you manage your investments but also can help you work through the emotions of investing, which can have a huge impact on your ability to reach your goals.
But how often do these market drops happen? Let’s take a look back over the past few years of market volatility as we demonstrate why these drops are an expected part of an investment journey.
Smoother sailing in 2017
Looking back, the year 2017 was a stock market anomaly: relatively calm with little market volatility. Throughout 2017, the S&P 500, a representative for US stocks, had no five percent loss events within a month period. That isn't to say an investor didn’t experience daily price movements holding the S&P 500, rather they just did not meet our minimum 5 per cent drawdown threshold.
Bumpiness in 2018
In contrast, 2018 had 3 such occurrences. The two biggest drawdowns in 2018 were 10.16% occurring between Jan 26th and Feb 8th and 19.78% occurring from mid-September to December 24th. The last drawdown of 2018 was particularly challenging for investors due to the significant drop in value many investors experienced. It also approached “bear” market territory which is generally defined as a price drop of 20% or more.
Patient investors rewarded in 2019
However, those who kept a level-head were rewarded for their patience in 2019. While 2019 experienced two periods where investors were down five percent or more within a one-month period, the S&P 500 ultimately had a very strong year. The index ended the year with a return of 31.49% in US dollar terms and 25.06% in Canadian dollars.
An investor who panicked would have sold at the end of 2018 and then, after the panicked feelings had subsided, would’ve likely bought back into a rising market. While very tempting, this activity is opposite to what we should practice as investors, and it can badly limit the compound growth of our investments.
March 2020 has already been a wild month with stock market circuit-breakers being triggered on 3 separate occasions. The circuit breakers were designed to curb panic-selling and algorithmic selling and the breakers have three separate triggers at various price points. As an example, the S&P 500 is halted if the index falls 7%, then the next trigger is 13% and the final trigger is down 20% from the previous day's close. The breakers trigger a 15 minute halt in trading, unless the market is down 20% at which point, trading is halted for the day.
In comparison to equities as measured by the S&P500, the US Investment Grade fixed income index (which represents the US bond market) only experienced one five percent drawdown in a one-month period once since 2002, during the 2008 financial crisis.
Frequency of volatility in the S&P 500
Number of times in a year each index has seen a 5% or more draw down event within a 1 month period.
Putting volatility in perspective from 2008 to now
It can be scary and almost seem counterintuitive to be told to hold on while you’re experiencing a loss. But with investing, it’s your best course of action.
Despite the short-term volatility stocks may experience, they help a portfolio appreciate in value over the long term. If an investor can stomach the short-term gyrations, there are significant rewards for long-term investors. From the March 2009 bottom of the financial crisis to March 16th, 2020, the S&P 500 experienced a total return of 344%, or 14.5% a year in US dollar terms.1
However, the path to achieving those returns wasn’t always smooth, as there were 25 drawdowns of 5% or more during that same time period from March 2009 to March 2020. Those represented 25 different opportunities for an investor to get nervous and question their long-term investing strategy.
The table below was published in an article by Ben Carlson, who took every month since 1926 in which the S&P 500 had a monthly return of about -8% to -9%, and then calculated the returns after each such month. Much like severe weather, volatility can seem very scary in the moment, but once the storm passes we are normally treated to sunny skies.
No two people are alike and everyone has varying degrees of “risk tolerance”, a fancy phrase for the amount of volatility (short-term ups and downs) with which an investor is comfortable. Consider the weather metaphor: some people live for chasing down the most intense tornadoes while some aren’t even able to tolerate a mild thunderstorm.
The same applies to investing. Some people are fine with lots of volatility and others prefer much less, and their long-term plans should reflect those differences. Volatility is not a reason to deviate from a long-term plan. If your plan made sense 6 months ago, and there have been no changes to your financial situation and goals, the plan remains appropriate even when we encounter more volatility.
A balanced portfolio is key to investment success
Many investors try to time the market and/or pick individual stocks, but neither of these activities are the primary drivers of a portfolio’s risk and return. Asset allocation is the single most important factor in the investment process.
Asset allocation refers to how a portfolio is apportioned among the main investment types of cash, fixed income, and equities. The overall goal is to create a portfolio that allows one to reach their financial goals and withstand short-term volatility.
For example, the CompassTM Balanced Portfolio is a split of roughly 45% fixed income and 55% equities. As shown in the table below, volatility was still present in the Compass Balanced Portfolio’s returns but in much lesser amounts than in the S&P 500 or an all-equity portfolio.
Frequency of volatility in Compass Balanced A
Nobody can predict with certainty the short-term direction of the stock market. Interest rates will rise and fall, stocks and bonds will appreciate and depreciate in value. Trying to predict and time the exact peaks and troughs of these events is a poor strategy that rarely rewards an investor.
Time in the markets is more important than trying to time the markets. Diversifying a portfolio and investing within an appropriate risk tolerance is the best course of action to achieve one’s financial goals. While perhaps less thrilling, this approach not only lends itself to long-term success, it also ensures a better night's sleep.
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