Last week, I have received several enquiries about the recent equity declines. What happened? Why did it happen? Is it going to repeat? Is this a new trend?
1. What Happened?
Stock prices have declined worldwide in September. As per the following table, Canada and Emerging Markets were the worst hit, while the U.S. and International Developed Markets (mostly Europe, Japan and Australia) were relatively spared. U.S. Large Cap stocks show a positive return in Canadian dollars because of the appreciation of the greenback, otherwise the return would be slightly negative. Lastly, Small Cap underperformed Large Cap in all regions.
2. Why did it Happen?
When markets move significantly, it is just human nature to look for an explanation. There will always be an army of experts who will volunteer to provide their view. But the terrible truth is: most of the times, nobody knows. Markets are complex systems and asset prices are driven by millions of human beings every day. No one can read their minds. Nor would finding the explanation for this market movement provide any benefit to your future wealth.
3. Is This a New Negative Trend?
Just like no one can reliably explain why returns were positive or negative in the recent past, it is also impossible to predict accurately what’s coming next. Some people believe that since we’ve had a fairly long string of positive markets since 2009, we’re due for a correction. I believe this conclusion is erroneous. There have been both longer and shorter stretches of positive returns in the past, and nobody knows when the current one is going to end. But while I can’t predict what the market is going to do, I’m confident that successful long-term investors will be those who stay invested and stick to their asset mix come hell or high water. In contrast, those who base their investment decisions on forecasts will likely fail.
4. Negative Months are Common
Although negative months have been less frequent since 2009, studying a longer history demonstrates that negative months are common. For example, since 1988, the S&P/TSX Composite Index has produced negative monthly returns 38% of the time. That’s almost an average of 5 months per year!
5. Investors Are Paid to Live With Negative Returns
We, as investors, tend to think of negative returns as something abnormal. But negative returns are frequent. The silver lining is they provide investors with a key benefit: a risk premium. Surveys among finance professors estimate the so-called “equity risk premium”, or the expected return difference between stocks and government bonds, to a 3 to 3 ½ % range. The entry price to this potential risk premium is to stay invested not only on a few negative months here and there, but also occasionally during prolonged negative periods.
6. What Diversification Does to Negative Returns
Capturing long-term positive stock market returns requires staying invested during the tough times. How do we do that? The key tool to do so is risk management and its corollary, diversification. The chart below illustrates the effectiveness of diversification in making risk manageable.
The red line depicts the frequency distribution of the Canadian bank stocks index (arguably, a concentrated portfolio since it includes only 10 stocks) monthly returns since 1988. Most often, returns were located between 0 and 5% (point A on the chart). But negative returns between 0 and -5% (point B) have also been very frequent. The problem with concentrated portfolios is illustrated by the far left tail of the red line: they, on rare occasions, experience extreme negative returns which are very damaging. In the case of bank stocks, they returned -28% on their worst month (point C). If someone had invested his entire $1,000,000 portfolio into banks, he would have ended that month with a $280,000 loss.
In contrast, this chart highlights that as we move from the most concentrated (red) portfolio to a more and more diversified one (successively black, green and blue), these extreme negative returns progressively disappear, leaving their space to more moderate ones.
September was a negative month in the stock market, but investors who owned U.S. and international stocks as well as bonds felt the shock far less acutely. Experts cannot predict markets, nor explain accurately why negative or positive returns occur. Their predictions and explanations result from guesswork. Therefore, market timing is useless, leaving diversification as the only reliable, time-tested procedure to manage your portfolio’s risk.
iA frequency distribution is a chart that describes how often a given asset class produced a return within a variety of ranges. At one extreme (far left) of the chart, documents how often returns were below -25%. At the other extreme (far right) the chart reports on how often returns were located between 15% and 20%.
iiCanadian Bank Stocks are measured by the S&P/TSX Canadian Bank Index; Canadian Stocks are measured by the S&P/TSX Composite Index; Global stocks are measured by 1/3 S&P/TSX Composite Index, 1/3 Russell 300 Index and 1/3 MSCI EAFE & EM Index; Global Stocks + Bonds are measured by 60% Global Stocks and 40% FTSE TMX Short Term Canadian Bond Index, rebalanced annually.