Market Decline

The year 2018 came to an end with a loud thud. Most asset classes recorded losses in the final quarter and investors getting their year-end statements are feeling a little shell-shocked from the sharp decline. I have received a few calls from nervous people and experience tells me that for every person that calls there are another 20 people with the same concerns that aren’t picking up the phone.

Those that are picking up the phone want to know that their advisor is aware of what is going on with their investments and to express their concern about this latest investment decline. The sentiment out there ranges from “I know this happens sometimes but I don’t like it” to “Should I be worried about this? Should we be looking at different investments?” I even had one person comment that it is “as bad as it’s ever been.” I’ve got to figure out that last person’s trick because 1000 hours of therapy hasn’t helped me block out the soul-crushing events of 2008 or the post-recovery pounding we received in the summer of 2011. No, this is not as bad as it’s ever been or even as bad as it appears. But I do accept that for some investors, especially newer investors, this may be as bad as they’ve seen it, and for retirees, it’s never a good time to see any level of decline. That’s why I’m writing this.
If we want to be able to make it through investment declines, we first have to understand why we’re invested in owning companies through the stock market (whether individual stocks or managed money like mutual funds) to begin with. I have spent many years observing the markets, invested in the markets, and learned from some of the best thinkers on investing like Don Connelly, Nick Murray and, of course, Warren Buffet. You will therefore be saddled with what I’ve learned from them.

The reason we invest in equities (company stocks) is because we realize that owners (equities) get paid more than loaners (fixed income). However, those higher earnings come with greater risk, or volatility, as we call it. As investors, we need to come to the realization that corrections or market declines are a necessary part of the process. It’s because we know that markets will temporarily go down that we insist on a higher rate of return.
If you go back through the markets over the last 70+ years there has always been a long-term relationship between the returns of the different asset types (I’m going to estimate numbers based more upon US market history since we have greater information and that market is much more diversified than the Canadian market). While the numbers vary depending on the time period you choose, they tend to look something like this:

Equities 10.5%
Fixed Income 5.5%
Cash 3%
Inflation 3%

That is as basic a lesson as possible about asset allocation. The more you own of the thing that goes up more than the other asset types, the greater your long-term results. But some investors shy away from equities because they’ve heard “they might go down”. Let me settle that concern for you right now: they WILL go down. It’s not a question of “if” they will go down, but more a question of “when” they will go down.

In the history of the markets, every time they go down, they come back up, and every time they come back up, they go on to set new record highs. So, in the long run, isn’t the thing that makes my net worth grow the most technically the safest place to be?

But the difference between the asset types is even greater than it appears above. If you take that inflation number and deduct it from all those assets classes to get the real rate of return, the numbers would look something like this:

Equities 7.5%
Fixed Income 2.5%
Cash 0%

When you go through this exercise, you realize that equities provide you with magnitudes greater return than the other assets classes (in fact, I hope you also see that cash is not a long-term investment asset to be considered at all). I’ve even removed from this comparison any conversation about the effect of taxes on the earnings of these assets classes. If I threw that into the mix, the vast majority of investors would run toward equities and never look back. But we don’t because we hear “they might go down.”

So, if you’re starting to see why it is so important to have as strong an exposure to equities as you can, why is it so difficult to translate a market decline as anything other than a mistake or a crushing defeat? The answer to that lies in human nature. As an investor, we love to see our money growing in value, but the danger is falling in love with the latest quarterly statement. When we see our latest statement is up, the danger is that we mentally record that number in stone and make it our new base acceptable bottom. We never want to see our balance drop below that value or else we become disappointed. It’s human nature and it’s understandable. We all love it when we see our portfolio balance go up but we can’t fall in love with the latest balance. If we want the greater returns that equities have to offer in the long term, we know we have to accept when they decline in value in the short term.

Someone once said the markets are like a man walking up a hill. The problem is while he’s walking up a hill he’s playing with a yo-yo. Our job as investors is to get our eyes off the yo-yo and get them back on the hill. Trust that your “hill” will head in the right direction in the long run.

I will talk more in depth about investment theory and the asset classes another time, but for now, let me leave the different readers with some closing thoughts on this subject.