Back in the first quarter of 2009, after a more than fifty percent bear market, as stocks began what has now turned out to be an historic, record-setting, eight-plus year ascent, every pullback, be it large or small, would generate a multitude of client phone calls worried about the preservation of their capital. This fear of loss or risk aversion is defined in an academic paper by S. Schulreich, H. Gerhardt and H.R. Heekeren as “a greater sensitivity to losses relative to gains of equal size.”
That said, from the bottom through this past week the S&P 500 has returned more than 200%, this despite several corrections of more than ten percent since the Q1-2009 bottom. Research by the Capital Research and Management Company found that corrections of at least 5% occurred on average 3 times per year and lasted an average of 47 days; 10% or more about once a year and last 115 days; 15 or more about once every 2 years and last 215 days and 20% or more once every 3½ years and lasted 341 days.
Given the fact that humans are generally risk averse coupled with the fact that small corrections occur on the average 3 times per year leaves little wonder that many retail investors are like a cat that sits on a hot stove. It will never sit on a stove again, be it hot or cold.
What is an investor to do? Focus on the long-term. To do this we analyzed three time frames, all of which include at least one bear market and two that include two. The first encompasses the prior ten years (Jan. 01, 2007 – Dec. 31, 2016) and includes the year 2008 when the S&P 500 dropped 38.49%. Despite this drubbing the compound annual growth rate of the S&P 500 for this period was 6.93%, not too bad when you consider the current yield on a 10-Year U.S. Treasury Note is about 2.20%.
The second time frame we analyzed includes the prior fifteen years ending December 31, 2016. Over this time frame, which again includes the 2008 bear market noted above as well as calendar year 2002 when the S&P 500 dropped 23.37%, the compound annual growth rate of the S&P 500 was 6.65%.
The final time frame we examined not only includes the declines referenced above but an additional combined decline of 23.18% during calendar years 2000 and 2001. Please note that Wall Street traditionally defines a bear market as one in which the market declines at least 20% from its high. With this final analysis, we have included at least three declines of at least 20% — 2008, 2002 and the combined 2002 and 2001. Despite these three calendar bear markets the compound annual growth rate of the S&P 500 over the trailing twenty years ending December 31, 2016 was 9.39%.
Investors would be well-served to not only focus on the long-term, but also to include their assets that are not at risk such as a defined-benefit pension plan or Social Security when determining the percentage that should be allocated to equities as compared to fixed income (bonds) and cash. Furthermore, please remove from the equation any short-term cash needs such as an emergency fund or such needs as the purchase of a home, car or other item within the next three years.
Despite all of this aversion to loss discussed above we have begun to notice investors inappropriately somewhat concerned about paying taxes on realized gains. This, we will address next week.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial adviser. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial adviser prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.