Damian Gallina, CFA
Alex, Gennadiy, and I recently attended a financial planning conference. Besides two and a half days of technical classes, we heard several keynote speakers, including an exciting, lesson-packed talk by Alison Levine, who led the first all female expedition up Mt. Everest. I’ve heard talks from other mountain climbers, but Alison was the first to explain the route climbers take between the four camps above base camp and the first to highlight how much time is spent climbing down the mountain to reach the summit.
After spending time at base camp (17,598 feet), climbers head to camp one (19,685) for a night, before returning to base camp to regain strength. Then they head back to camp one, advance to camp two (21,000), and then...all the way back down to base camp again. This process called acclimatization happens again as climbers trek to camp three (23,625) from the base, and then...back down again. Only once they reach camp four (26,085) do they head for the summit (29,029) without climbing down the mountain again. The whole process takes over two months, but the payoff is no doubt exhilarating.
You can probably imagine the thrill of making it up Mt. Everest, and the parallel with the market is easy to draw even if it lacks the adrenaline rush. Since 1950 the market price of the S&P 500 has increased 174 fold! Dividends added even more to those results. Along the way, however, the market spent some time climbing down before resuming the ascent that marked all of that wealth creation.
Source: Yahoo! Finance
If you have ever thought the market can feel like it takes two steps forward and one step back, it turns out you are a wild optimist.
For some time, I’ve wanted to write about how often the market rises or falls on its overall journey higher. Jeff and I compiled the data for this article before I heard Alison’s talk, and we thought about the data in a way that exactly matches the description of her team’s Everest expedition route.
The trek down from camp one to base camp and back covers 4,174 feet of elevation with no progress other than getting strong enough to advance higher. The similar round trip from camp two and back was another 6,804 feet, and to secure camp three, they traveled 12,054 just to reach the highest point they already had. In the whole effort to climb 11,431 vertical feet, Alison and her team spent 23,032 feet losing and recovering elevation they’d already reached.
If you have ever thought the market can feel like it takes two steps forward and one step back, it turns out you are a wild optimist. After analyzing the S&P 500 price data from January 1, 1950 through October 1, 2018, we found it is more like 100 steps forward and 93 steps losing and recovering lost ground. To identify every period of decline from an all time high, Jeff and I marked each high point, the lowest depth from that high point, as well as the number of trading days for the market price to eventually recover the lost ground. Here is a summary of the data and the lessons that follow...
Yahoo! Finance, Buttonwood Financial Advisors
You might quickly notice a few things. First, out of 17,299 market days, 16,024 were spent either losing or recovering lost ground. That seemed like a lot to Jeff and me, but we point out that dividends aren’t included in the price level of the S&P 500, so really you are at least making some money during those recovery periods. Next, smaller declines are very frequent, but recover quickly, while less frequent and more severe declines will still happen several times over your investing lifetime. The worst of them can take years of recovery. Finally, you probably intuitively know that if you need more than you can earn in cash or bonds, you’ll have to venture into stocks anyway.
Buttonwood’s Investment Policy Statement is a Plan to Handle Investing Reality
Another well-spoken climber I’ve heard focused his talk on the importance of making it home alive. In that respect, our investment philosophy incorporates many aspects designed to survive the setbacks and enjoy the bursts of real wealth creation that happen between all these drop and recovery periods. Our clients will know these elements well, but we hope this story and our inferences from the data reinforce them in an interesting way...
There are many slippery spots on the mountain, but most are minor. Drops under 5% in severity are recovered in days or weeks, taking place every couple of months. Over the course of 68.75 years, bigger drops of 5-9% happened every other year on average, but also averaged just a few months for recovery. The longest lasted just over a year from February 2, 1994 to February 13, 1995.
- Relax: We believe more money is lost trying to avoid declines than by the declines themselves. Reading each frequent drop as the “big one” risks many false alarms, and then missed opportunity.
- Buy quality: We believe in buying quality businesses worth owning on bad days. Better yet, worth adding to, particularly when they go on sale.
You can’t make it all the way up the mountain if you are forced to drop valuable supplies. Corrections of 10-20% occurred about every 4-5 years on average. On average, these also took only months to recover. Even the longest only needed 18 months to recoup a 14.02% decline.
- Keep a cash reserve: You need a reasonable cash reserve to draw against so you aren’t forced to sell good companies for bad prices when these deeper declines happen. We target a year in cash, plus the dividends and interest that accumulate over the year, to weather these occasional setbacks.
AVALANCHE! You may have to take a slower route to avoid these dangers, but it is better to make it up the mountain, if only slower, versus getting wiped out. Bear markets with declines that wipe out a quarter, third, or even half of stock values cause understandable fear. These less frequent events are triggered by fundamental shifts in the economy. They happen about once a decade on average, taking several years to recoup.
- Keep a secondary reserve: You need a bigger reserve to draw against for these bigger events that take longer to recover. Beyond a year in cash, we typically target another three years of bonds for our clients who make scheduled withdrawals. We often further recommend the Diversified portfolio, which includes additional bonds as a tertiary reserve. All of these reserves are extended through the accumulation of dividends and interest over those years.
- Don’t pay any price to chase the most exciting stocks: We prefer businesses with more current profits (value style) versus more expensive businesses that sometimes don’t live up to the hype. We won’t begrudge those that are successful, but we don’t want to risk securing your future by ignoring irrationally high prices.
- Diversify: We are humble enough to diversify among companies, sectors, geography, and asset classes so that you have many sensible opportunities over a lifetime.
Plan everything before you get started. Our financial plan solves for the rate of return you’d better achieve to secure your finances. We use this insight to help our clients adopt an approach and then stick with it. The plan also considers efficiency pick ups, like tax savings, as well as threats, like disability or a premature death.
- Stocks whether you like ‘em or not: Most investors we meet need more return than they can achieve from cash and bonds. Knowing your required return will help you understand your unique need for stocks and remind you to stick with the plan when things get volatile.
- Limit yourself to sustainable withdrawals: Withdrawing from your portfolios at a sustainable pace (4-6% depending on your age) helps prevent running out of money late in life.
- Be efficient: Our plan estimates your tax liability by year to highlight different strategies for high bracket versus low bracket years. Strategies that make the most of the tax code for you may be very different than for your friends.
- Insure against risks you can’t handle: If you can’t suffer a loss of income or handle unplanned expenses, purchase insurance to cover these threats.
Our analysis of the S&P 500 price data quantified a sober picture we’ve always sensed and described...The market delivers its returns in bursts. Given that reality, we have to be practical about the real human needs of our clients who’ll spend money over the course of a lifetime. We can’t live in the theoretical world of academics...perpetual saving without spending, immortal time frames, and no taxes or trading costs. Our financial planning and investment policies are designed for that reality, and we find ourselves more confident that we are on the right path after conducting this analysis.
Thank you for trusting Buttonwood to navigate your personal and financial realities.