Well it’s been quite a long time since I lasted posted a lesson on here. From managing the chaotic life of doing MBA while working full time, the craziness still has not detracted my attention from the recent volatility of global markets, and the entrance into correction and/or bear territory that many global equity markets have seen, including my own portfolio!
However, if one is investing for the long term, these short-term disturbances in any account should be ignored. Even for the more prudent investor, trying to time entries and exits from equity markets is difficult, especially during periods of volatility when the market can easily move a few percent in either direction during any given day or week. Most of the time, even the most sophisticated finance expert will find it difficult to judge when economies will experience some level of correction, and potentially enter bear market territory. When such a realization is made, it is usually too late to do anything about it. For the long-term patient investor, this realization may be meaningless. There is still some value in being able to recognize a bear market in order to better allocate one’s money during the short term and the importance of understanding the fallacy of buying high and selling low. For the purposes of this post, let’s focus on Canada and US equity markets.
A bear market is defined as a market that has fallen at least 20% from its high within a 52 week period, or calendar year. A market correction is defined similarly in that a drop of at least 10% has occurred from the market high within a 52 week period. Market corrections are quite common, happening usually every 3 to 5 years on average for the Canadian and US markets, while bear markets average every 7 to 10 years. Downward market sentiment can continue during a correction phase and lead to a bear market. Bear markets can occur within any asset class, or it can be market wide. The average bear market in the US lasts 1.4 years, with an average cumulative loss of -41%. The chart below illustrates the historical trend of bull and bear markets of the S&P 500 since 1926 (First Trust Portfolios).
Figure 1: S&P 500 Historical Bull and Bear Markets
The chart clearly illustrates that bear markets do happen, but the markets are biased to the upside heavily, with bull markets capturing the majority of the timeline. Also evident from the chart is that bear markets do not always coincide with economic recessions, and vice versa. A recession is identified when a country’s GDP declines for two straight quarters. This usually marks a slow down in the economy, with increasing unemployment, low inflation, decline in trade activity, decline in industrial production, and very little corporate earnings growth. In other words, any slowdown in the components that make up GDP can trigger a recession (i.e. personal consumption, public and private investments, net exports, and government expenditure). Subsequently, a recession is typically reflected in a severe decline in the relevant economy’s equity markets, leading to a bear market.
Finally, the chart above shows the importance of ignoring emotional trading and buying high and selling low. Canadian and US markets are biased to the upside simply because of long sustained economic growth, stable inflation, growing local and foreign investment, and long sustained growth in corporate earnings due to competitiveness and innovation. Obviously picking the tops in this chart to be 100% cash in one’s portfolio, and then deploying all of this cash at the bottoms is the ideal scenario. In hindsight, anything seems obvious, and to actually do this while markets are experiencing extreme volatility both to the upside and downside is difficult. Human irrational behavior can definitely erase anyone’s chance to successfully time entry and exit into markets (see Lesson 32), but also the fact that none of us are crystal ball holding genies that can tell the future might be another reason why timing entry and exit is difficult.
For the vast majority of individuals who are not familiar with the intricacies of global economies and equity markets (or don’t have time to because it’s not part of their every day job), ignoring market swings and committing to dollar cost averaging into index funds or one’s diversified portfolio is always encouraged. Averaging the same North American annual equities market return of 7% and compounding that over a number of years will payoff greatly in the long run when retirement becomes reality. Having a portion of one’s portfolio invested in risk free securities, such as bonds, at all time can help soften the impact of market declines on one’s portfolio, and a gradual shift of one’s capital to more risk-free securities over time as retirement nears is ideal. The impact of market declines is felt a lot heavier if one’s retirement is near, since the amount of time available for compounding returns in the future to “recoup” such loses is limited (this will be explored in more detail in future lessons). Regardless of the percentage of one’s portfolio invested in public equities, having a portion of cash on the side ready to deploy when markets are suffering tremendous declines and trending near a bottom can also be very beneficial due to the effect of compounding from a bottom over the long run.
So don’t be afraid to look at your portfolio balance and global market trends to see whether a bear market or market correction is imminent or in the current spotlight, because being able to deploy capital here will give an inevitable boost to one’s portfolio performance going forward.