A common false criticism of investing in the stock market is that it is nothing more than gambling – a big, unpredictable game of chance manipulated by the “house.” In times of high volatility as we are currently experiencing, this refrain is repeated more frequently. We think that is a false characterization. History has shown that the odds are firmly in the investor’s favor over time, but there’s no denying that portfolios have not had a strong set of cards in the past few months as both stocks and bonds have had one of their worst starts to the year ever. At its recent lows this May, the S&P 500 was down over 18%, bonds as measured by the Bloomberg US Aggregate Bond Index were down 10.5%, and the Nasdaq Composite, down 28%, almost matched its early COVID pullback level from 2020.
A pullback greater than 10% is commonly called a “correction,” while anything over 20% is referred to as a “bear market.” These are arbitrary percentages and nomenclatures, but nevertheless, the pain in investors’ portfolios is real. The S&P 500, down 18% since January, is firmly in correction territory and flirting with a bear market. However, these pullbacks are not uncommon. Since 1950, there have been 38 corrections for an average of 1 every 1.85 years – and these include corrections that ultimately turned into bear markets. The average length of a correction was 188 days (about 6 months), and we are now almost 5 months into the present one. In addition, 65% of these corrections took 3.5 months or less to recover, and we do know this: 100% of all 38 corrections have eventually recovered to new market highs.
It is important to note that we don’t know when this market will recover and there is no shortage of bad news continuing to feed the negativity: inflation is high and proving stickier than anticipated, the Fed is increasing interest rates which risks throwing the brakes on the economy, large parts of China are shut down due to their zero-COVID policy, and the Russian/Ukrainian war lingers on. Investors fear that all these factors together will ultimately lead to a recession, in spite of economic and earnings data (of which we’ve talked consistently) that have not shown significant signs of cracking. We know that earnings and economic data are backward looking and the market is forward looking, so this pullback is clearly saying two things:
Number 2 has already been happening, while number 1 is not yet evident – but the fear is certainly there.
This recession fear is leading to the volatility and uncertainty that we are currently witnessing. In fact, this opinion has become so pervasive that negative investor sentiment is reaching a crescendo. Individual and Institutional investor surveys are close to some of the most negative readings in their history. Anecdotally, it seems as though every guest and commentator on financial TV channels has a bearish view as well. When everyone seems to be on one side of the bearish boat, historically this has often been a positive signal. In this chart of the University of Michigan Consumer Sentiment Index, we see that after this index hits lows near these levels, 1-year market returns are typically positive by double digits averaging well over 20%.
We’ve been dealt a string of bad hands and it feels like the “casino” has been taking some of our winnings. How do we turn the tables to get the advantage back? There are two ways to do this: by not trying to time the market and by investing for the long-term.
While the market is down it can be a natural impulse to sell off to “stop the bleeding.” But timing the market requires two correct decisions – not just when to get out, but also when to get back in. Getting back in is a difficult proposition at best because our emotions keep us from being able to buy when the headlines are still bleak (and they always are at market lows). The right time to buy the market never really feels like the “right” time to buy. On top of that, being out of the market for just a few positive days can have a substantial impact on returns. In fact, missing the top 5 days in the market every year for the last 20 years would have cut your return from 9.5% annualized (staying in the market) to -6.5% annualized. Being able to predict precisely when the 5 best days are going to be is impossible, and often those best days cluster around the worst days, further adding to the difficulty.
Finally, turning the tables in your favor also requires taking a long-term approach to investing in the market. We maintain that dollars invested 100% in the equities market should have at least a 10-year time horizon to weigh the risk of volatility against the potential for growth. The market can be quite volatile in the short-term but has provided more consistent returns over longer time frames. To demonstrate this, we looked back at the market over the past 100 years and calculated returns over the course of all possible holding periods. We found that the odds of generating a positive return substantially improved as you lengthened your holding period. For a 1 day holding period, the odds of success were little better than a coin flip. As the holding period increased, so did the odds of a positive return. At 5 years the chance of success jumped to 88%, while at 10 years it reached a 95% chance of a positive return, and that actually jumps to over 98% at 10 years if you exclude the Great Depression era. While we can’t guarantee what future returns will be, we certainly like those odds. Avoiding market timing and investing for the long term are two of the best ways we know to turn gambling into investing and to stack the investing odds in your favor.