November 2008

When will the good times return?

After the two months of market turbulence we’ve just experienced, some people are asking a very reasonable question:  Will we ever get back the money we’ve lost? And if so, when?

No need to go into detail:  since July, anyone with money in the stock market have seen some investments decline by up to 40%, according to certain indexes. Can such losses be recovered? History says yes. Providing that you do the right thing... and, more importantly, avoid doing the wrong thing.

Math 101

To begin with, we need to remember a very simple mathematical rule:  a 50% decrease does not equal a 50% increase. If our investments lose 50% of their value, a subsequent return of 50% on those investments will not be enough to get us back to our starting point. Instead, our investments will have to gain 100%, because the invested money will have dwindled by half. Thus, someone whose portfolio went from $10,000 to $7,000 this past fall has experienced a loss of 30%. To get that back, the return on investment has to be not 30%, but 43%.

Better forget about it? If you are swayed by what you read in the papers, yes; if you go by what has happened in the past, no.

Market dynamics

Because the markets are influenced by investors’ expectations, predictions, and emotions, they are volatile by nature. The result:  on average, you can expect to lose money in the stock market one year out of every three. Here’s the flip side, though:  in the other two years, you will make money – and sometimes a lot of money. Since 1920, Canada’s S&P/TSX index has posted 29 bear years, with returns averaging -12%. But it has also recorded 59 bull years, with an average return of +17%.  After a loss, logic tells us that if we stay in the market long enough we will make it all back and, in the long term, earn even more.

Of course, there’s long… and then there’s long. After the Great Depression of the 1930s – an extreme example – it took the markets more than twenty years to recover completely. The successive crises of the 1970s also tested investors’ patience. But over the long term, markets are clearly bullish.

Human nature

Faced with a loss on investments, an investor can decide among a number of different approaches. It is educational to look at studies establishing how long it would have taken investors to recover their money using these different approaches after another major stock market crisis, the one in 1974. These studies are based on the S&P 500 index, the best gauge of U.S. markets, and on the assumption that the person had made his or her investments in Canadian dollars at the peak of the market. Here’s what they show:

  • 6 years to recover losses
    if the person liquidated the portfolio to seek refuge in guaranteed investments
  • 5 years
    if the person sold everything, then reinvested in the market a year later
  • 2 years
    if the person held onto their equity
  • less than 2 years
    if the person doubled their initial investment, either in a lump sum or by periodic deposits.

In this example, the best course of action was to hang onto the investments – and even invest more.

Averaging your cost

The example shows that a depressed market opens a rare window for the opportunistic investor – including those who have just watched their existing investments tank badly. Imagine, for instance, that an investor put $10,000 into a fund with units trading at $100 each (i.e. 100 units). Over the following 18 months, this investment loses 50% of its value. But instead of panicking, the person remains confident about his choice and, after a momentary hesitation, purchases another $10,000 worth of units, this time at $50 each (i.e. 200 units). So the investor now owns 300 units.

Now let’s imagine that three years after the initial investment, the unit price goes back up to $100. What happens? Our investor’s stake in the fund is now worth $30,000 (300 units at $100 each), after a total investment of only $20,000. That’s a substantial return… especially given that the units only rose back to their initial value.

Time is better than timing

Another factor also argues in favour of staying in the market:  stock market returns are never linear. It is impossible to predict with any accuracy when the next surge will be. In fact, if you happened to be out of the market for just the best 20 days out of the past 10 years, you would miss out on 80% of the returns. And if you missed the best 30 days… your returns would actually be negative! We can’t say it enough:  the length of time you are in the market is much more important than exactly when you get into or out of it.

But… can you take the heat?

Finally, for all of us as investors, a financial crisis has one virtue:  it can be very revealing.

The stock markets became much more democratic over the course of the 20th century:  today, anyone can get into the market with a small investment in a mutual fund and hope for a solid long-term performance from that money. But market dynamics have not changed at all. Risk and volatility is still the name of the game. And it’s one thing to state in your investor profile that you’re okay with temporary losses of 40% – but it’s another thing to actually see that kind of loss hit your portfolio.

What should they do? As we have already demonstrated, liquidating their portfolio at a loss is far from the best choice. However, we are seeing the arrival of a growing number of investment vehicles that offer to take the market risk for the investor, providing guarantees as to capital, growth, and retirement income. These are complex products and come with higher fees. But people who would like to stay in the market even though they can’t handle the associated risk should look into them. A portfolio revision is indispensable when your situation changes and you find that your risk tolerance is no longer the same.

As for everyone else, remember that analysts are predicting an end to the financial crisis and the global recession within a year or two, with the help of government bailouts and lower oil prices. So two, three... five years – and maybe more – could go by before stock prices climb back to their pre-crisis levels.

Plenty of time – here’s the bright side – to carry on investing year after year and to end up earning a more than satisfactory return on your investments.