3 Critical Lessons For Market Declines



The following is adapted from Marlena Lee's recent article published by Dimensional Fund Advisors (DFA). While Aspen Leaf Wealth Management, PBC pursues socially responsible investing beyond the scope of what DFA offers, we share many similar philosophies based on research and evidence.



INTRODUCTION


While stock market declines can feel turbulent & uncertain, investors who embrace volatility and short-term unknowns have historically been rewarded.


Unless you have a crystal ball (you don't, no one does), reacting to market declines is a surefire way to derail progress. Here are three timely lessons to remember when stocks slide.



A RECESSION IS NOT A REASON TO SELL


Are we headed into a recession? A century of economic cycles teaches us we may well be in one before economists make that call.

But one of the best predictors of the economy is the stock market itself. Markets tend to fall in advance of recessions and start climbing earlier than the economy does. As the chart below shows, returns have often been positive while in a recession.


Source: Dimensional Fund Advisors. In US dollars. Recessions shaded in green. Stock returns represented by Fama/French Total US Market Research Index, provided by Ken French and available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. This value-weighed US market index is constructed every month, using all issues listed on the NYSE, AMEX, or Nasdaq with available outstanding shares and valid prices for that month and the month before. Exclusions: American depositary receipts. Sources: CRSP for value-weighted US market return. Rebalancing: Monthly. Dividends: Reinvested in the paying company until the portfolio is rebalanced. Growth of wealth shows the growth of a hypothetical investment of $100 in the securities in the Fama/French US Total Market Research Index from July 1926 through December 2021.

Whether accompanied by recessions or not, market downturns can be unsettling. But over the past century, US stocks have averaged positive returns over one-year, three-year, and five-year periods following a steep decline.

A year after the S&P 500 crossed into bear market territory (a 20% fall from the market’s previous peak), it rebounded by about 20% on average. And after five years, the S&P 500 averaged returns over 70%*.


Market declines or downturns are defined as periods in which the cumulative return from a peak is -10%, -20%, or -30% or lower. Returns are calculated for the 1-, 3-, and 5-year look-ahead periods beginning the day after the respective downturn thresholds of -10%, -20%, or -30% are exceeded. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following the 10%, 20%, and 30% thresholds. For the 10% threshold, there are 29 observations for 1-year look-ahead, 28 observations for 3-year look-ahead, and 27 observations for 5-year look-ahead. For the 20% threshold, there are 15 observations for 1-year look-ahead, 14 observations for 3-year look-ahead, and 13 observations for 5-year look-ahead. For the 30% threshold, there are 7 observations for 1-year look-ahead, 6 observations for 3-year look-ahead, and 6 observations for 5-year look-ahead. Peak is a new all-time high prior to a downturn. Data provided by Fama/French and available at mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama/French Total US Market Research Index: 1926–present: Fama/French Total US Market Research Factor and One-Month US Treasury Bills. Source: Ken French website.

Staying invested puts you in the best position to capture the recovery. If you take risk out of your portfolio, it should be a strategic, not tactical, choice. The only good reason to sell out of a stock portfolio now—so long as it’s diversified and low-cost—is because you learned something about your risk tolerance or your investment goals have changed.


It might feel like you should be doing something with your portfolio right now. Should I layer in additional commodities, real estate, or private equity? Does an indexed annuity make sense? Should I play the tactical market timing game and sell to cash and get back in later?


All of these are valid strategies, but only if you know what the market peak (already passed, you're too late) and market bottom (TBD) are. If you can't identify these moments in advance, messing with your strategy means you're locking in losses after the market has declined and simultaneously sabotaging your return during the rebound.


The best advice I have is to accept the market's return and rebalance to maintain your target risk profile. Any other tactic adds risk- the thing we're trying to minimize.



TIME THE MARKET AT YOUR PERIL


This lesson is so important it gets its own content section.


When stocks have declined, it might be tempting to sell to stem further losses. You might think, “I’ll sit out until things get a bit better.” But by the time markets are less volatile, you’ll have often missed most of the recovery. Yes, it stings to watch your portfolio come down from its high water mark, but imagine how you’ll feel when it’s stuck in neutral while the market rebounds.

Big return days are impossible to predict, and you really don't want to miss them. If you invested $1,000 in the S&P 500 continuously from the beginning of 1990 through the end of 2020, you would have $20,451. If you missed the single best day, you’d only have $18,329—and only $12,917 if you missed the best five days**.

History shows the stock market tends to rebound quickly. The same can’t be said for individual stocks or even entire sectors. So, while investing means taking on some risk for expected reward, investors should mitigate risks where they can.


Diversification is a top risk mitigation tool, along with investing in bonds, controlling for cost, and having a financial plan.



REASSESS YOUR PORTFOLIO AND FINANCIAL PLAN


We saw many fads crop up through the pandemic, from baking to puppy adoption. Did you experiment with one of the pandemic investment fads like NFTs, crypto, or meme stocks? If so, you probably got in too late and lost money. Now you have a problem; can I stomach holding onto this losing position until it (hopefully) rebounds or do I cut my losses and do something else?

Switching gears, do you know the names of all the stocks you own? Then you probably own too few. How much of your portfolio sits outside the US? Did you know that about half the global market is comprised of foreign stocks?


If you only invest in the S&P 500 (large caps), you’re missing more than half of the investment opportunity set. A market-cap-weighted global portfolio is a better starting point than chasing segments of the market that have outperformed in the past few years.


The ESG model I use for client accounts holds 2,687 underlying individual stocks and more than 2x that many individual bonds. Almost half of the stocks are domiciled outside the US. It's hard to achieve more global diversification than this.

And if you want to outperform the market, allow decades of academic research to light the way. Portfolios focused on small caps, value stocks, and stocks with positive ESG correlations have been more profitable and have had higher returns over the long run.


Click here to view the outperformance figures of the KLD 400 Social Index over its conventional benchmark over the last 1, 3, 5, and 10 years. Stay tuned for an upcoming in-depth analysis of returns for all the funds in our model portfolio.



FINAL THOUGHTS

Beyond a well-designed portfolio, the best way to manage volatile markets and disappointing returns in the short term is to have planned for them.


We are all CFP Practitioners® at my firm. We approach retirement income planning by analyzing events such as market declines, reduced Social Security, and inflation. By parsing through our client's numbers, we build plans that bake in the chance you’ll experience strains on your portfolio's ability to produce income.


If you're a client and want to check in on your financial plan, I'm happy to share your updated numbers. If you haven't hired us yet, feel free to initiate a discussion by using the "Contact" link at the top right of this page.


The last thing I'll leave you with is that I agree that this market sucks. I empathize and feel it too. However, I want you to know I practice what I preach. It's important to me that you know I'm not full of BS. Just last week my wife and I followed our own advice and took excess bank cash and invested.


We knocked out our annual backdoor Roth IRA contributions, family HSA contribution, kid's 529 plan contributions, and queued up my company's 401(k) match. We also maintained our monthly employee 401(k) contributions ($1,708/mo each) to max out for 2022 ($20,500 each). All said and done, that represents $92,300 worth of contributions flowing into our tax-deferred investment accounts.


Yes, we save a lot, but I don't detail our personal saving habits with any kind of ego. I bring up our numbers to lead by example. We went all in, the same advice I would give to a client. Having too much bank cash is a greater risk to wealth than investing new money during this down market.


I get that it's yucky to move "safe" money into what feels like a losing investment. I might not thank myself tomorrow, but I will in a few years.


You might point out that I'm probably younger than you (I'm 43) and that I have a lot of time so why should I worry about the market right now. I hope you're correct in that I have a lot of time, but you're off base in that I can't think of a single client that is planning on exhausting their entire portfolio in the next several years, even those that are the most "seasoned". The commonality is that we all intend to invest money for more than just a handful of years.


You're in it for the long haul, same as me. Get invested and stay invested. Stick to your long term plan.






* S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.


** Past performance, including hypothetical performance, is no guarantee of future results. Growth of $1,000 is hypothetical and assumes reinvestment of income and no transaction costs or taxes. The analysis is for illustrative purposes only and is not indicative of any investment. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. Indices are not available for direct investment.