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January 20, 2016
Advanced Investing Market Research

Bad Times

Give the bear a hug: periods of losses are key to building wealth.

Stock markets around the world have been in decline since the beginning of 2016. Most investors have seen any gains of last year wiped out in two weeks. A British bank attracts a lot of attention with the advice: “Sell Everything”. Under these circumstances it is easy to lose sight of our investment goals that span years, if not decades.

A major academic text on investing opens with the sentence: “The two most important words in investing are bad times.” The central idea is that the ability of an investor to endure bad times that others shy away from is fundamental to growing long term wealth. Bad times must be endured to capture the additional return that deters others. How often do we have to endure bad times, how bad are they and what is the reward?

To give a visual sense of how often bad times occurs we have plotted the monthly returns of a global stock market indexi for the period January 1994 to November 2015 (Figure 1). Everyone’s idea of a bad time is slightly different, depending on individual circumstances. We define a bad time as a return in the month of less than -5%. Conversely, a good time is a monthly return of greater than +5%. The bad times are in red and the good times are in blue. Investment returns between these two extremes are considered unremarkable and coloured light grey. The first thing to notice is that bad times only occur 6% of the time. Often bad times are followed shortly after by good times, which poses a challenge for those who like to move in and out of the market trying to anticipate short term events. In practice many of our clients are invested in a balanced portfolio close to 50% equities and 50% bonds. Figure 2 shows the results for a balanced portfolio indexii: it is rather boring. Bad times occurred on only 1% of occasions (3 out of 263 months) illustrating the ability of bonds to reduce the frequency and severity of losses.

Source: Dimensional Fund Advisors (DFA)

 

If we look at periods longer than one month then we get a sense of how long bad times may endure. Figure 3 looks at 3 month returns on a rolling basis and Figure 4 looks at 12 month returns, also on a rolling basisiii. Over longer periods of time we expect to be more certain of a positive return – otherwise why would we invest? The likelihood of any three month period being a bad time is 41 times out of 263 (or a probability of 16%). For 12 month returns the likelihood of a bad time is 14 out of 263 (or a probability of 5%). Conversely the likelihood of a good time over any 12 month period is 184 occurrences out of 263 or 70%. Patience is rewarded.

Human nature being what it is, we are much more dismayed about bad times than we are pleased with the good times. Investing is not much different from other human endeavours in that we may all want certain outcomes, but they require a struggle. The struggle for investors is enduring the bad times.

As for the outcome, an investor who put $100,000 in the 50% balanced fund in January 1994 would have seen it grow to $379,000, an average annual return of 6.3%iv.

Source: Dimensional Fund Advisors (DFA)

 

i DFA Canadian Global Equity Index

ii DFA Canadian Global 50/50 Index

iii Indices are not directly investable.

iv In the case of 3 month returns, a rolling return is for every 3 month period, stepping forward one month. A 12 month rolling return is for every 12 month period, stepping forward one month.

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