By COSMO DeSTEFANO
History doesn’t repeat itself but it often rhymes.
— Mark Twain
Almost every modern-day investment for sale to the public comes with a version of the following disclaimer: “Past performance is no guarantee of future results,” but that doesn’t mean the past should be ignored, or worse forgotten — especially as we view our financial plan with a holistic mindset. When it comes to understanding financial planning and investing, having a firm grasp on the history of the markets provides critical foundational knowledge.
Throughout history, the markets have repeatedly been through boom and bust cycles (think dotcom bubble, the global financial crisis, the COVID-19 induced drop, or for a much older perspective, Tulip Mania — to name just a few). And more broadly when not booming or busting, the markets are usually traveling less dramatically up over time, and then down (or correcting) over time. Market cycles, extreme or not, are remarkably persistent.
It’s déjà vu all over again.
—Yogi Berra
So, if market cycles repeat, why don’t we simply follow the pattern to buy at the bottom and sell at the top? Cycles mimic the past in general terms (e.g., what goes up usually comes down and vice versa), but timing and duration don’t have identical historical timelines. Industries, companies, information flow, political climate, investor sentiment, etc., constantly change and shift. That’s why pinpointing the beginning or end of a particular cycle does not subject itself to formulaic analysis.
As an investor, however, understanding the history of financial markets and the relative position within a cycle (e.g., early- or late-stage; over- or under-valued) can help you assess risk and evaluate investment opportunities; but as far as pinpointing the exact optimal time to execute a trade, not so much.
Whether market returns have been strong to date (higher than long-term averages), or weak to date (lower than long-term averages) will help us assess where in the cycle we sit. And from this vantage point (the current relative level of returns) we can start to make an informed assessment of where returns are likely headed, even if we can’t say exactly when.
Prices and future returns are inversely related
Unless current market returns are approximately equal to the long-term historical average, you should not expect to receive the average return going forward. As the current market’s yield moves away (up or down) from the long-term average, your expectations about future returns should move as well; in the opposite direction!
For 25 years, JP Morgan has been producing its annual Long-Term Capital Market Assumptions (LTCMA) providing their assessment of 10-15-year return projections for various asset classes.
Reversion to the mean
History teaches us, and JP Morgan reiterates this fundamental truth: prices and future returns are inversely related. As the price of stocks rises, future returns will likely be lower. And the converse is true: As prices fall, future returns will likely rise. Reversion to the mean pulls averages towards their long-term trend line.
Your life expectancy and withdrawal timeline play an enormous role in the outcome of your Financial Independence (FI) plan. If you have decades before reaching your FI date, using long-term market average returns might be a reasonable planning assumption for now. If you are close to your FI date (say within 5-7 years), the long-term averages are less relevant, and you should focus on variable rates based on current valuation levels.
Those of us close to or actually withdrawing from our FI Portfolio should be focused on income and capital preservation. In such a scenario, your FI plan should manage the real risk of a drop in near-term equity returns. For example, consider holding more cash. Rebalance within equities to focus on dividend payers versus pure growth investments. Interest, dividends, rents from real estate, etc. all serve to cushion the blow of market value declines. Investing in growth stocks with high valuations combined with a short timeframe is the opposite of conservative.
Don’t confuse ‘average’ with ‘expected’ return
The long-term average market return (S&P 500 Index) is approximately 10% (1957-2022). The average is a simplistic summation of the long-term, but it doesn’t tell us much about the here and now. This reminds me of some statistician humor: There is a rather tall gentleman who lives in a rather small house. When he lays down his head is in the oven and his feet are in the freezer. When asked how he felt, he responded, ‘On average, I feel fine.’
Annual market returns are anything but average. How often does this S&P 500 Index average return actually occur within the ‘I feel fine’ range of say 8-12%? In the 65 years since 1957, the annual return has been in the 8-12% range exactly 5 times. That’s it. And the actual range of returns has been negative 37% (2008) to a positive 43% (1958) — a spread of 80 percentage points!
Smart money is simply dumb money that’s been around the block a few times
Following the 1932 bottom, the market return for the next 20 years averaged 15.4% per year. For the 20 years following the 1974 bottom, 15.1% per year. And for the 11 years following the March 2009 financial crisis bottom, 16% per year. Investing near the bottom of a market has proved time and again to be a profitable long-term strategy, but it takes a strong stomach to jump in and stay in when it seems that everyone else is running away.
What to do? If you’re an investor in individual stocks, do your homework, and focus on company fundamentals. If you’re a passive index investor, keep investing. Yes, indexes come down too, but index funds don’t file for bankruptcy and lose 100% of an investor’s capital even if an individual company contained in the index does disappear.
See the present with clear eyes
As individual investors, we can learn from historical markets and our own investing experiences. Keep your head out of the sand and pay attention.
Our goal with better understanding the past is not to predict the future but to see the present with clear eyes. To understand on a relative basis where the markets — and its participants — are today so we may better position our portfolio (aggressively or defensively). It is about relative decisions, not absolutes.
Be mindful of your goals
It’s not about trying to time the exact top or bottom of a market. It is about situational awareness. For long-term investors, it’s evaluating where we are in the current economic cycle so we can better assess what is likely to follow (but by no means guaranteed to follow). Don’t go on your merry way investing with your eyes wide shut.
For example, if in your estimation, the markets are closer to over-valued than under-valued maybe consider keeping a little extra dry powder (i.e., cash) on hand to take advantage of tactical opportunities, opportunistic investing, but not wholesale strategic changes. Remember, our goal is meeting our future FI spending needs not timing or beating the market.
Practise situational awareness
It’s not our planned actions that usually get investors in trouble, but rather our unplanned reactions to market events (e.g., selling after a crash; or chasing overvalued stocks ever higher.) We need to develop our situational awareness. We can’t possibly predict every bear market cycle or market crash, but we can better prepare psychologically for when dramatic market fluctuations inevitably arrive.
So we beat on, boats against the current, borne back ceaselessly into the past.
— F. Scott Fitzgerald
In 1997, Barry P. Barbash of the U.S. Securities and Exchange Commission delivered a speech at the ICI Securities Law Procedures Conference in Washington, D.C. In summarising his thoughts, Barbash observed, “We must remember the past because it has so much to teach us… We have an opportunity to learn from history and, in doing so, to avoid the pitfalls of the past. I can only hope we take full advantage of the opportunity.” Channeling the philosopher, George Santayana, Barash concluded, “Some of us would prefer not to remember the past…But perhaps the only thing worse than remembering the past would be to relive it.”
We need to use all the information we have at our disposal to make better informed, probability-based decisions while always weighing the cost and consequences of being wrong.
You need to understand the current landscape and monitor changes that might impact the future. And when you fold those observations into your plan, do not forget or unlearn the lessons history has taught us.
© The Evidence-Based Investor MMXXIV. All rights reserved. Unauthorised use and/ or duplication of this material without express and written permission is strictly prohibited.