By Angel Clark
How much impact does the news, and the emotion-driven decisions it causes, have on the stock market's long-term growth? Loring Ward, a firm that provides investment management services to independent financial advisors and their clients, posed their theory via a clever YouTube video in which the viewer embarks on a journey through seven decades of Time Magazine headlines as they plot the growth of a single $1.00 invested in the U.S. stock market from 1927-2012.
The video illustrates the market's incredibly persistent rise despite being hit again and again with what should be crippling news. Corrections, sometimes severe, were unavoidable but inevitably healed with time and the market came back stronger than before. The moral of the story, as I see it, is "don't worry, be happy;" you should stay in a state of rosy complacence because the market will always triumph in the end. I wonder if they would feel the same if their portfolio was down 40-60% and they were looking to retire next year... or if this is just advice that should be given to clients?
Personally, I think that staying the course and trusting that everything will be okay can deliver pretty severe consequences, ones that most investors (if they're human, awake and not an adviser) don't have the fortitude to withstand. The pain you, as an individual investor, experience during these sizable corrections often causes your trading common sense to fly out the window – sometimes permanently. Hope, Fear and Greed take turns jumping into the driver's seat, ready and willing to take your portfolio for one heck of a wild ride. Let's look at the possible impact of these ill advised trips and what you can do to avoid them.
- Greed decides that the gravy-train is never going to end and convinces you to keep buying despite dangerous, overbought situations. Put the pedal to the metal! Even when a correction comes, Greed cheers that this is a killer buying opportunity! So what if you're holding a 20% loss. If you buy more now you can lower your cost-basis and dollar-average your way to being a multi-millionaire in no time! After all that's what the pros say to do and they must know what they're talking about. Uh-oh. Now your portfolio has slipped another notch. And another.
- Hope gently nudges Greed out of the way. Okay, things are bad, but they're not that bad. Things could definitely be worse. The market will turn around with tomorrow's open. It always does, just hang in there kiddo, everything will be okay before you know it. But it isn't.
- Fear shoves Hope out the driver's side door and plunks itself behind the wheel. Is there no end to the bad news? Horrible headlines - plunging earnings, political debacles, global catastrophes – get out while you still can! This crazy ride is over, Fear slams on the brakes. Everything is liquidated to preserve as much of your nest egg as still possible, just in time for the market to take off and leave you in its dust.
But the market doesn't have to have the last laugh. The good news is that it's entirely possible to put your emotions to take a back seat.
You can still take advantage of the temptingly high, long-term returns from investing in the stock market without the masochism of enduring 40%+ market corrections -- and it doesn't involve sticking your head in the sand or handing your investments over to "someone that knows what they're doing." Let's look at the upside, and your solutions to emotional joy rides.
Look at the first chart below, from February 28, 2000 to January 3, 2014 the S&P was up 35% (2/28/00 closed at 1348.05, 1/3/14 closed at 1831.47). Exactly as the Loring Ward video shows, the market managed to overcome a barrage of bad news to wind up higher than it ever was. Yet, investors that started investing fourteen years ago would only have an average annual return of 2.5% (35%/14 years). Certainly not a return that is appealing enough to withstand the two nightmare corrections that are evident on the graph -- this is where buy and hold advocates get the short end of the stick. Blindly holding stocks through major corrections (bear markets) is the very reason for the lackluster average returns.
The first correction, from February 28, 2000 to October 10, 2002, the S&P gave back 46% and during the second correction, from October 11, 2007 to March 6, 2009, the S&P gave back 57%. Now that's something you don't forget. Ever.
The FIX: Now, let's take a look at an easy solution to navigate around the worst of these losses without giving up our long-term investor status.
The next graph shows two simple moving averages of the S&P 500 - a 150-day and a 200-day. The crossover of these moving averages gives a clear signal of when to protect profits (i.e. time to sell) and when it's time to go shopping (i.e. start buying stocks again). This should keep you on the road to buying low and selling high – before it's too late.
These moving averages provide clear signals but how effective can they be? Since we know the S&P is up 35% for our period and has encountered corrections of 46% and 57% respectively, our highest possible, shoot-for-the-moon gain would be somewhere around 138% (35+46+57). We might not hit the moon but we should be able to get a good distance off the ground.
Using the chart above the first date that we can conclusively determine the 150-day moving average is below the 200-day moving average is December 12, 2000, the S&P closes at 1371.18 on this date. Using this as our exit, we would have avoided 42% of the 46% drop. Almost. There was a short signal from 5/13/02-7/9/02 where the shorter-term moving average managed to creep over the longer-term, thereby giving us the signal to get back into the market. The consequence would have been an 11% loss in the S&P during that time. In total, these signals avoided 31% of the original 46% drop... not bad.
Following this same method, the S&P would have received six 'sell' signals in the 14 year period shown by the chart above. Acting on these signals resulted in a total S&P 500 gain of 60.2% vs. the 35% cited above. There were two periods that ended in losses, the biggest loss being 11.3% vs the 57% loss encountered during the '08 bear market. (P.S. just because we're using the S&P for our example, doesn't mean you couldn't use the same method on the Nasdaq, Dow, Russell 2000, etc., which all showed similar trends.)
This objective approach provided road signs for the market's direction and delivered a substantial improvement with minimal effort. Volatility and the size of the market's corrections were drastically reduced. Using stop-losses and smart money management techniques could enhance the results even further, as could adding a few more timing rules for a slightly more sophisticated market-timing system. Just remember, when you're evaluating a rule-based market timing system, the efficacy goes beyond accuracy. It sounds crazy, but it's true.
Every indicator and system used for the market is flawed. There will be plenty of false signals, it's not atypical to see accuracy at 50% or below. The real winners are the systems that adapt fast enough to reverse the signal and get you out of those bad situations quickly. Accuracy and adaptability must balance to provide you with a good system.