Visualising The Damage on The Stock Market

Bed goes up, bed goes down, bed goes up, bed goes down.

– Homer Simpson

Since the GFC stocks have been the perfect place to hide. In fact, there has been no safer bet with stock markets around the world trading at multiples of their GFC lows. Here’s how major stock markets around the world performed (total return) since the bottom of the GFC:

(orange line – Australia, purple line – Asia, green line – Europe, blue line – US, red – Emerging Markets)

Only when the tide goes out do you discover who’s been swimming naked.

– Warren Buffett

Financial markets however, have no regard for what you want or what you need, and will turn on you like the Melbourne weather leaving you perplexed as to which season it is.

The recent spasm of news coverage on the stock market correction prompted me to assess the damage done on stocks. For the last two months, these were the headlines investors have been reading – how exciting!

I’m not sure who defined a market correction being a decline of 10% or more, but it’s the widely accepted definition. What good is it for investors to know that the correction has begun based on some meaningless threshold someone fabricated? Why is the threshold not 12%, or 15%? Why should a manufactured definition trigger investors to revisit their investment strategy? To me, this threshold seems illogical, and to base investment decisions on these definitions seems foolish.

Let’s take a look at what all the fuss is about. Here’s a chart showing the total return of the above indices since 8 October (when the decline began) to Friday, 23 November 2018:

Within two months, the US stock market is down 10.69%, Europe is down 9.05%, Asia down 7.97%, Australia down 5.92%, and Emerging Markets down 5.25%. Having said this, if we were to look at peak to trough using 52 week highs, the chart above would look different again. In fact, Emerging Markets would look a lot worse if we pulled the start date back to earlier on in the year. It doesn’t matter where you were invested your money, there really was nowhere to hide.

If you think that’s bad, just spare a moment for the tech investors. Here are the FAANGs (Facebook, Apple, Amazon, Netflix, Google) against the S&P500 (orange line) and Nasdaq (grey line):

(purple line – Facebook, green line – Amazon, blue line – Apple, yellow line – Google)

Hey, what do you expect after a run up like this:

Netflix’s market cap is currently sitting at US$112 billion. To put that into perspective, Citigroup is currently valued at US$150 billion. Number of employees at each company: Citigroup – 209,000, Netflix – 5,400. Revenue (2018 est): Citigroup – US$216,000,000, Netflix – US$16 billion. Net income (2018 est): Citigroup – US$18 billion, Netflix US$671 million.

Markets can remain irrational for a lot longer than you and I can remain solvent.

– John Maynard Keynes

Most money managers will highlight and emphasize performance for a select period of time (I’ll let you decide why), so it’s very useful to me (and investors) to look at things through a wider lens. So here it goes – the recent market declines since the GFC for stock markets around the world:

It comes as no surprise that the asset class that has performed the best over the last 10 years is the one that has fallen the most when things are seem a little uncertain.

Even following a market “correction”, the US stock market is still up 265%, the Australian market up 144%, and Asia, Europe, and Emerging Markets up 123%, 80%, and 59% respectively.

There are several narratives that are making headlines justifying the recent market decline. The general theme goes something like this: This bull market has been running hot for almost 10 years. Interest rates are rising, and cost pressures are rising, which will cause inflation. Whatever narrative you decide makes most sense to you, the reality is that the news that is floating around is not new and is probably priced into current market valuations anyway.

At the end of the day, the more you pay for an asset, the less the future expected return. The less you pay for an asset, the greater the future expected return. In life, and in financial markets, things sometimes just don’t make any sense – although they eventually do. Don’t try and keep up with the Jones’ or get caught up in the market and media hype – it takes guts, discipline, patience and time to make money.

When you decide to embark on the journey of investing, remember the wise words of Homer Simpson – bed goes up, bed goes down.

Source:

  • Charts and headlines – Thomson Reuters
  • Returns are denominated in AUD for all charts except the FAANGs

Here’s What Happens When You Invest at Market Peaks

PT Barnum is often credited with coining the phrase, “there’s a sucker born every minute.” History buffs argue the famed circus founder instead stated, “there’s a customer born every minute.” When it comes to investing, the words “sucker” and “customer” could be interchangeable.

As human beings we are drawn to the idea of the future being predictable. And anyone that, for one second, purports to be able to have some insight into what the future hold, we’re hooked – yet as clear as day, we all know these folk hold no insight whatsoever.

It’s tough to make predictions, especially about the future.

– Yogi Berra

Financial markets are no exception. We want to avoid the tops and pick the bottom, we want to avoid paying top dollar, and pursue bargain basement prices. Yet when we find ourselves in the midst of euphoria or a crisis, we tend to follow the crown.

Try to be fearful when others are greedy, and greedy when others are fearful.

– Warren Buffett

What if you just had shear bad luck when investing? What if you weren’t able to avoid the tops? Even worse, you retired precisely when the market peaked?

Ben Carlson of A Wealth of Common Sense ran these numbers for a US based investor, so I decided to run the numbers for an Australian based investor. We’ve got three investors, James, Frank, and Steve. They each retire just before the stock market peaks with AU$1,000,000 invested 70% in the Australian share market (S&P/ASX All Ordinaries Index – Total Return), and 30% in Australian bonds (Bloomberg AusBond Bank Bill Index). They also draw 4% of their portfolio at the beginning of each year to help fund their retirement. I’ve also assumed the portfolio is rebalanced once a year, and I haven’t taken into account fees or taxes to keep things simple.

Here’s what I found:

  • James retired on October 1987,
  • Frank retired on June 1998, and
  • Steve retired on September 2007.

Here are the returns adjusting for inflation:

Trying to time the market for it to add any benefit to your investment returns is super difficult. Investing at market tops prior to retirement hasn’t been as destructive as one would have assumed – although it could be. The analysis shows a somewhat diversified portfolio that is structured, disciplined by rebalancing, and an investor’s who remains patient without getting in and out of the market, their portfolio can remain quite robust through their retirement. Of course, the longer one invests for, the better the financial outcome – who would have thought.

The best time to invest is when you have the money.

– John Templeton

The Disease of Kings And King of Diseases

The disease of the kings and the king of diseases dates back to Egypt, 2,600 BC. In 1963, Thomas Sydenham, an English Physician described its occurrences so very accurately.

Those who fall ill to the disease are either old men, or men who have worn themselves out in youth as to have brought on premature old age—of such dissolute habits none being more common than the premature and excessive indulgence in venery and the like exhausting passions. The victim goes to bed and sleeps in good health. About two o’clock in the morning he is awakened by a severe pain in the great toe; more rarely in the heel, ankle, or instep. The pain is like that of a dislocation and yet parts feel as if cold water were poured over them. Then follows chills and shivers and a little fever… The night is passed in torture, sleeplessness, turning the part affected and perpetual change of posture; the tossing about of body being as incessant as the pain of the tortured joint and being worse as the fit comes on.

Today, the disease is more commonly known as gout – the term dating back to around 1200 AD, and is typically a combination of diet and genetic factors. There are certain things that make it worse, and others that make it better.

Last week I fell ill to the disease of kings, and boy, it certainly earns its name – king of diseases. If you’ve never experienced the pain, the torture this illness brings, ask someone who has and they will describe pain of dislocation, and fractured bone. Whatever you do to try and alleviate the pain, it’s merely temporary. The disease needs to be treated before it hits.

Like the disease of kings, investing too cannot be left untreated – one can simply not look for immediate relief when one has not made the right decisions for years prior.

Here are three key principles to apply when investing for the long-term that will ensure you’re not looking for the pain killers when things go south:

Start investing early

Unlike most things in life, you can start investing as early as you like. The chart below shows the impact starting early has on the end balance of your portfolio. It shows four investors each saving/investing $5,000 annually. Just take a look at Consistent Chloe’s portfolio, and compare it to that of Late Lyla – it’s almost half the value only having started 10 years later!

Source: JP Morgan

The power of compounding

Whether Einstein called it the eighth wonder of the world or not, it matters not. What matters is how powerful such a small decision can be. The chart below shows the difference between reinvesting dividends and distributions and without – almost four times the amount!

Source: JP Morgan

Stay invested

By trying to time the ups and downs of the market, history shows time and time again you’re going to lose money.

The chart below shows us the return of an investor who remained fully invested in the Australian stock market from 1996 through to 2017 – they earned 9% pa. If they had missed just the 10 best days during that time, their return fell to 6.50% pa. If they missed the 20 best days during that time, they return was halved – 4.60% pa, and so on.

Source: JP Morgan

Looking for short cuts and get rich quick schemes in the midst of great pain is like taking pills at the peak of illness expecting it to solve all your problems. I just ain’t gonna happen.

Sources: JP Morgan, Wikipedia, Gout – The Affliction of Kings

This is the Biggest Risk to Your Portfolio

Academically my background is in financial and risk management. During university I studied the usual stuff, economics, corporate finance, and probably the subject that most interested me was statistics. We learned about portfolio construction, risk, diversification, correlations, R-squared, standard deviation, gamma, delta, and the list goes on. We spent a lot of time optimising portfolios and assessing possible risks that may impact the portfolio’s performance.

One of the biggest things I’ve learnt since coming out of the academic world and into world of people and money, is that you cannot diversify away from human behaviour. The cognitive biases that are inherent in all human beings are the biggest risk to our portfolios. It’s not the Fed raising rates too quickly, it’s not deflation, inflation, or hyper inflation, it’s not property prices crashing, it’s not trade wars, it’s our cognitive biases and poor understanding of how markets work that destroy our wealth.

It was 10 years ago the GFC tore through world markets and was on the verge of paralysing our economy for good. But it didn’t. And you would have thought as investors, we would have learned a lesson or two from this experience. Nope – we have gained no new wisdom, nor have we gained any further self awareness.

The lessons that can be taken from the GFC will remain in history books forever, and you will hear old folk tale from investors decades from today.

At a financial markets conference in New York, Cliff Asness did precisely that. “We are not market-timing”, said the large endowment fund, “but we will probably return to U.S. equities in the spring.” Rarely at a loss for words, Asness was left sputtering and speechless.

At the same conference Bill Miller told this story: He presented the idea of buying junk bonds in December 2009 to a large firm’s investment committee. At the time, the bonds were trading at 22 cents on the dollar, but the idea was rejected by the committee as too risky. Five years later the fund bought these same bonds at a much higher price and much greater risk. (Miller was not involved in that transaction).

These errors led Asness to observe, “You can have a committee of 10 geniuses that proves collectively to be a moron.”

As can be seen from the below chart (click for larger image), financial markets have rewarded long-term investors. Investors who have a game plan in place, who have taken the long view, and who have remained disciplined and patient.

Source: Vanguard

I get it, it’s super hard. And this is precisely why financial research and literature is littered with evidence that human behaviour is the biggest detractor of performance, also known as the ‘behaviour gap’.

The below research, conducted by Dalbar, clearly illustrates how difficult it is to remain focused on the long game. The average investor over all time frames has underperformed the market. For example, over the last 20 years, the average equity fund investor returned 4.67% pa, whereas the S&P500 returned 8.19% pa. The average investor underperformed the market by 3.52% pa. The investor simply had to do nothing and their portfolio would have returned 8.19% pa for 20 years. Yet they chose not to. They succumbed to their human biases and did something, which detracted from their performance.

Don’t do something, just stand there.

– Jack Bogle

They could have spent that time doing things they loved; built a business, spent time with their family, traveled, rebuilt an old muscle car. But they chose not to. They chose to “manage” their own money.

Source: Dalbar

Here are the specific causes for underperformance, with investor behaviour making up a staggering 42% of the loss (1.50% pa of 3.52% pa).

Source: Dalbar

As the scars of the last financial crisis heal, we plant the seeds for the next crisis that will again decimate financial markets. And next time it won’t be different, it will only seem that way due to our inability to learn from our prior experiences, a failure to understand our own limitations, and poor risk management. Blame no-one but yourself.

Godspeed.

Source: Dalbar, Vanguard, Bloomberg: The Next Financial Crisis is Staring Us in the Face