The smallness of the army renders the natural strength of the community an overmatch for it; and the citizens, not habituated to look up to the military power for protection, or to submit to its oppressions, neither love nor fear the soldiery; they view them with a spirit of jealous acquiescence in a necessary evil, and stand ready to resist a power which they suppose may be exerted to the prejudice of their rights. (Federalist Papers, Alexander Hamilton)
A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil. Let’s explore why.
Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium. In fact, in twenty-three of the eighty-two years from 1926 through 2007, or close to 30 percent of the time, the S&P 500 Index produced negative returns. In addition, there have been periods when the S&P 500 Index produced severe losses:
- January 1929–December 1932 it lost 64 percent.
- January 1973–September 1974 it lost 43 percent.
- April 2000–September 2002 it lost 44 percent.
The very fact that investors have experienced such large losses leads them to price stocks with a large risk premium. From 1927 through 2007 the S&P has provided an annual risk premium over one-month Treasury bills of just over 8 percent. If the losses that investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk that investors perceive, the higher the price are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.
The bottom line is that bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil. We can extend this logic to the risks of investing in small and value stocks.
Small-cap and Value Stocks
We know that small companies are riskier than large companies. Therefore, the market prices small-cap stocks to provide higher returns than large-cap stocks. From 1927 through 2007, small-cap stocks have provided an annual risk premium of 3 percent. However, small-cap stocks have not always outperformed large-cap stocks. If they always outperformed, there would be no risk of investing in them relative to investing in large-cap stocks—and there would be no risk premium. For example:
- January 1969–December 1974, small-cap stocks underperformed large-cap stocks by a total of 47 percent.
- January 1986–December 1990, small-cap stocks underperformed large-cap stocks by a total of 33 percent.
- January 1994–December 1998, small-cap stocks underperformed large-cap stocks by a total of 30 percent.
Further evidence of the risk of investing in small-cap stocks is that while the small-cap risk premium has been 3 percent, the annual standard deviation of the premium, at over 13 percent, has been more than four times the premium.
We also know that value companies are riskier than growth companies. Therefore, the market prices value stocks to provide higher returns than growth stocks. From 1927 through 2007, value stocks have provided an annual risk premium of 5 percent. However, value stocks have not always outperformed. If they always outperformed, there would be no risk of investing in them relative to investing in growth stocks—and there would be no risk premium. For example:
- March 1934–March 1935, value stocks underperformed growth stocks by a total of 43 percent.
- June 1998–February 2000, value stocks underperformed growth stocks by a total 44 percent.
And, as was the case with the small-cap premium, the value premium is volatile. The annual standard deviation of the value premium, at just under 13 percent, has been more than 2.5 times the premium.
Risk Premiums and Investment Discipline
The bottom line is that the outperformance of stocks relative to Treasury bills, small-cap stocks relative to large-cap stocks and value stocks relative to growth stocks is not what economists call a free lunch—there are risks involved. And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.
It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest. Consider the results of a study by Morningstar. Morningstar found that in all seventeen fund categories they examined the returns earned by individuals were below the returns of the very funds in which they had invested. For example, among large growth funds the ten-year annualized dollar-weighted return was 3.4 percent less than the time-weighted return (the return reported by the fund). For mid-cap growth and small-cap growth funds the underperformance was 2.5 and 3.0 percent. Investors in sectors funds fared worse, with tech investors producing particularly disastrous results, underperforming by 14 percent per annum. The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low. It is almost as if investors believe that they can buy yesterday’s returns, when they can only buy tomorrow’s.
There are several explanations for this outcome. The first is that investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.
The second explanation is that investors are overconfident of their ability to deal with risk when it inevitably shows up. They believe that they can stomach losses of 20, 30, 40 or even 50 percent and still stay the course, adhering to their plan. However, the evidence demonstrates that investors are as overconfident of their investment abilities as they are of their driving skills (studies have found that the vast majority of people believe they are better than average drivers).
The third explanation is that investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.
The Keys to Successful Investing
There is an old adage that “those who fail to plan, plan to fail.” Therefore, the first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan. And that means having the discipline to stay the course just when it will be most difficult to do so (partly because the media will be filled with stories of economic doom and gloom). What is particularly difficult is that staying the course does not just mean buy and hold. Adhering to a plan requires that investors rebalance the portfolio, maintaining their desired asset allocation. That means that investors must buy stocks during bear markets and sell them in bull markets. That brings us to the second key to success.
While academic research has determined that almost all of the risk and return of a portfolio is determined by the portfolio’s asset allocation, the actual returns earned by investors are determined more by the ability to adhere to whatever the allocation they chose than by the allocation itself. Thus, the second key to successful investing it to be sure that investors do not take more risk than they have ability (determined by their investment horizon and stability of income), willingness (risk tolerance) and need (the rate of return needed to achieve their objectives) to take. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.
The third key to success is to understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try. Consider the evidence from two studies on market timing. Tactical Asset Allocation [TAA] is just a fancy name for market timing. For the twelve years ending 1997, while the S&P 500 Index on a total return basis rose 734 percent the average return for 186 TAA mutual funds was a mere 384 percent. Just as impressive is the results of a study on the performance of 100 pension plans that engaged in TAA: Not one single plan benefited from their efforts. If the results of these studies are not enough to convince you, perhaps the following from legendary investor Warren Buffett will. Listen carefully to his statements regarding efforts to time the market:
- “Inactivity strikes us as intelligent behavior.”
- “The only value of stock forecasters is to make fortune-tellers look good.”
- “We continue to make more money when snoring than when active.”
- “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”
Buffett also observed: 
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
Perhaps Buffett’s views on market-timing efforts are best summed up by the following from the 2004 Annual Shareholder Letter of Berkshire Hathaway:
Over the 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback Corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.
The above observation is perhaps why Buffett has stated that investing is simple, but not easy. The simple part is that the winning strategy is to act like the lowly postage stamp that adheres to its letter until it reaches its destination. Investors should stick to their asset allocation until they reach their financial goals. The reason it is not easy is that it is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets. In fact, bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.
Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn. But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns. It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.
The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create). Put the plan in writing in the form of an investment policy statement and an asset allocation table and sign it. That will increase the odds of your adhering to it when you are tested by the emotions caused by both bull and bear markets. And then be sure to stay the course, altering your plan only if your assumptions about your ability, willingness or need to take risk have changed.
- Morningstar FundInvestor (July 2005).
- David Dreman, Contrarian Investment Strategies, p.57.
- Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992).
- 1996 Annual Report of Berkshire Hathaway.
- 1992 Annual Report of Berkshire Hathaway.
- 1996 Annual Report of Berkshire Hathaway.
- 1991 Annual Report of Berkshire Hathaway.
- 2006 Annual Report of Berkshire Hathaway.
- Financial Analysts Journal, November/December 2005, p. 51.
Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.