Key Post A rough year

Marc

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This analysis was originally in sterling but the conclusions are just a valid for a Euro investor.

September and October were torrid months for global markets.

Market falls are unsettling for investors, leading to questions like, “what if this time is different, what if markets never recover? Should I be doing something different?” It’s tempting to be lured into safe haven assets like cash, but that would be a mistake.

The naked truth about risk

  • Risk is the reason why excess returns are available. It is uncertainty that causes assets to be priced at a discount so that investors can expect to be rewarded for taking that risk. If an asset was suddenly perceived to be less risky, it’s price would immediately shoot upwards and the future expected return would fall. Risk is the reason we are able to retire. But risk isn’t just some academic concept. Bad things (like the financial crisis of 2008 or the technology bubble popping in 2000) need to actually happen periodically to preserve the “equity risk premium”. In other words, if bad things didn’t happen and people perceived equities to be less risky, assets would price at a premium and expected returns would need to be moderated. The same goes for any sell-off in any asset class.
  • These episodes are expected. Below is a statistical simulation over 40 years of a Profile 6 portfolio with an expected return of CPI + 4.5% and expected risk (volatility) of 12.4%. The risk and return achieved in this single simulation is almost exactly as expected; however, the path is clearly not smooth.


Because of compounding, this chart tends to obscure risk in early periods and exaggerate it later on. Below, I have used a log or exponential scale on the y-axis to more intuitively represent returns over long periods, which is why the CPI +4.5% line is now straight and not curved with compounding. Values are “real” and exclude inflation.



This would be a very satisfactory outcome for an investor in this portfolio who saved from the age of 25 to 65. But this investor would have had to endure a few bumps along the way.

Given the turmoil experienced in markets in October, we used the simulator to see how “normal” such falls are for a portfolio with the same asset allocation as the profile 6 portfolio. The chart below shows how many times in 40-year investment periods monthly losses exceed 2.5%, 5%, 7.5% and 10% respectively. This is derived from running 500 simulations and taking the average:



This means that on average over 20 occasions in a 40-year investment period there were monthly losses that exceeded 5% i.e. once every two years. In other words, these negative periods should be anticipated; they are quite simply consistent with an investment with even this reasonably modest risk profile. The knowledge doesn’t necessarily make losing money any more comfortable, but it does provide perspective. When looking at an historic chart, it’s easier to contemplate those big dips because you can see the recovery – living through them takes more grit!

If all these anticipated negative months seem like too much of a threat to one’s sleep and there is a concern that composure may evaporate (the biggest risk to wealth accumulation by far), let’s see the impact of down-risking to a Profile 4. The expected return for Profile 4 in the simulations is CPI + 3.3% with a risk of 8.4% (again, the expected risk based on this asset allocation held passively – historically lower in real life within our actively managed portfolios). The numbers improve markedly:



Instead of almost 21 instances of monthly returns below -5% in each 40-year period, there are now only just over 3 on average in 40 years.

But if one is likely to sleep better in a profile 4, at what cost? Here are the returns of the two simulations compared:



However, to make it easier to comprehend visually, I used a log or exponential scale on the Y-axis. Let’s see what happens when I remove that scale:



In the Profile 4 simulation (which closely approximated the expected return), the investor’s £1 grew to £3.71 in real terms over 40 years, whilst the Profile 6 simulation grew to £5.82. In other words, the Profile 6 simulation grew the investor’s asset base by 57% more than Profile 4. That is a big number.

Risk is not just about volatility but needs to include the risk of not accumulating enough assets. This shortfall risk is the elephant in the room and is too often ignored as investors focus on shorter-term fluctuations. Return in itself is a buffer against risk. I am not advocating against lower-risk portfolios as they play an important role in matching portfolios to investor objectives (such as meeting a required return at the lowest possible risk). I am simply emphasising the long-term expected cost of smoothing out returns too much.

Market timing

Finally, market timing is a mugs game and the truth is that there is a mountain of academic and empirical evidence that suggests that market timing is really, really hard and the outcomes tend to be somewhat random.

The corollary is that those who believe that they have the only crystal ball in town (and who make big, dramatic risk-on, risk-off trades) tend to make a horrible hash of running portfolios (eventually). If it were as simple as moving into cash when markets were expected to fall and going back in when they were expected to bounce, you’d have a money printing machine – in fact, you wouldn’t share your secret and manage other peoples’ money, you’d keep it to yourself, mortgage your grandmother and invest selfishly on your own behalf. Selling out after taking the losses and buying back in after markets recover is a wealth destruction strategy that has no equal.

 

Brendan Burgess

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  • Risk is the reason why excess returns are available.
  • These episodes are expected.
Marc

That is very reassuring and very timely.

Academically, I am happy to stay fully invested in equities, but having had a bad year - it sort of shakes my confidence a bit. Your post restores my confidence.

Thanks

Brendan
 

Cervelo

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This would be a very satisfactory outcome for an investor in this portfolio who saved from the age of 25 to 65. But this investor would have had to endure a few bumps along the way.



I cant help but wonder if the investor had bought in at month 100 how satisfied they would have been with their portfolio performance over the next 200 months (16+years)
 

Marc

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Great question.

As luck would have it during the accumulation stage, if you are saving, the sequence of returns has virtually no impact on the compound annual growth rate.

However, if one had retired at month 100 and invested 100% in equities and immediately taken withdrawals of capital from the portfolio. Then, yes there would be a substantial problem.

Managing decumulation in retirement is absolutely critical and the first 3 years of investment returns have a disproportionate impact on your financial security for the whole of the rest of your life.


https://www.askaboutmoney.com/threa...k-about-retirement.210617/page-3#post-1592937
 
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joe sod

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I cant help but wonder if the investor had bought in at month 100 how satisfied they would have been with their portfolio performance over the next 200 months (16+years)
maybe thats the period we have just traversed now as a european stock market investor, the last peak was in year 2000 but we still have not taken out the year 2000 high. I agree with the analysis above but sometimes investors need enormous patience and today with all of the noise from the media and the fact that there was a major property bubble and now another one in that period investors take their money out of the market and dont even put it into the market (like most irish people).

The euro stoxx 600 index has been mentioned in other postings , surely a european index with 600 stocks in the second most important financial market in the world is fairly well diversified yet the performance has been abysmal, surely someone with better knowledge than I could answer this.
 
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Zebedee

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Very good article. Thank you.

Re “mugs game” I would add drip feeding. There have been academic articles on this also. What you might gain on the way down is lost on the way up. Apparently a simple 50/50 bonds/equity strategy has beaten this.
 

galway_blow_in

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maybe thats the period we have just traversed now as a european stock market investor, the last peak was in year 2000 but we still have not taken out the year 2000 high. I agree with the analysis above but sometimes investors need enormous patience and today with all of the noise from the media and the fact that there was a major property bubble and now another one in that period investors take their money out of the market and dont even put it into the market (like most irish people).

The euro stoxx 600 index has been mentioned in other postings , surely a european index with 600 stocks in the second most important financial market in the world is fairly well diversified yet the performance has been abysmal, surely someone with better knowledge than I could answer this.
Europe is more exposed to financials and the likes of energy in terms of fund allocation, both sectors have gone nowhere in twenty years and in the case of financial stocks,, way down
 

noproblem

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For an ordinary Joe Soap like myself and i've asked investment questions over the past few months, I would also like to say thank you to Marc. It's not that you've answered any questions, per se, but the reassurance and pointed explanations are really helpful to the likes of me. They aren't awfully off putting in tone or substance, they speak in an easy way and can be understood by the common man. I've read over them a few times and each time they make more sense. Thank you again.
 

joe sod

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As the original poster said it has been a very rough year for investors, the last few weeks in particular have been unprecedented with big falls day after day on little real news. Its obvious that trading algorithms have exaggerated the moves that were taking place just like at start of 2016. It seems that when moves happen they happen rapidly and swiftly much more than in the past, yes the crashes in 1929 and 2008 were much bigger but it is the speed of the moves today that are new. Its probably the case that this sort of movement is going to frighten amateur investors from ever investing in the stock markets at all.
 

lledlledlled

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A rough year ago indeed. By little other than pure fluke, I cashed out of most of my equity holdings to prioritise mortgage overpayments and other priorities, just before most of the big declines this year.

I also started in my employer's occupational pension scheme at the beginning of the year and never got around to changing from the default Mixed Asset fund to 100% equities, which had been my intention.

I've been pretty well convinced over the years reading this an other forums that over time, equities will outperform other asset classes. And although I'm trying to ignore the 'this time it looks different' articles, I'm struggling to convince myself that I shouldn't sit tight with the Mixed Asset (lower risk) allocation for 2019 and see what the market is like in 12 months.
I realise this strategy completely goes against the advice that amateur investors should never attempt to time the market but even the most bullish advisors seem to think we're in for a very volatile 2019, if not a year of correction.

I know we can't discuss individual shares but does this sound sensible?
 

noproblem

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You lucky little vixen, at least that's my response and, if it was me I would continue to ride my luck. So yes, we're in choppy seas and the weather forecast is for plenty more sudden and prolonged gusts. If you're in safe harbor stay wrapped up and the damage should be minimal. That is, unless you have a nice dry house with good carpets that are fee from vermin of the pest and human variety, in that case, cash in and stick said funds under said Axminster and enjoy walking all over it every day:)
 

joe sod

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I think someone else pointed out that if you are out of the market on certain crucial days when the market experiences huge rises , then you miss out on most of the gains. Well it seems yesterday was one of those days, one of the biggest rises I have ever experienced and I am not really sure why. Sometimes the market does these crazy schizophrenic things that defy rational reason but you need to be onboard when it happens
 

galway_blow_in

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I think someone else pointed out that if you are out of the market on certain crucial days when the market experiences huge rises , then you miss out on most of the gains. Well it seems yesterday was one of those days, one of the biggest rises I have ever experienced and I am not really sure why. Sometimes the market does these crazy schizophrenic things that defy rational reason but you need to be onboard when it happens
Blowout jobs report in the usa, mumbles from the fed chair about flexibility, Chinese government flexibility re_ their central Bank

European financials and autos were priced for deep recession already, pe of 5 for some of the banks in Europe with BV of half in many cases
 

cremeegg

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I'm struggling to convince myself that I shouldn't sit tight with the Mixed Asset (lower risk) allocation for 2019 and see what the market is like in 12 months.
That thinking is a clear demo of why most amateur investors loose money.

The S&P at 2,500 is 12% below the 2,800 it first reached last Jan and continuously traded above from July to Oct last. Now is a better time to buy than last July, Aug, Sept, Oct.

What more can be said.
 

PMU

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What more can be said.
A lot more. You should never confuse price with value. Invest now in the S&P when Nobel Prize winner Prof Robert Shiller's CAPE (cyclically adjusted price earnings ratio) for the S&P is 29.7 and you can expect low future returns while it reverts to its long term mean of 16.6. https://www.starcapital.de/en/research/stock-market-valuation/.
I'm all for rebalancing your portfolio to match your asset allocation strategy – I do it myself on an annual basis – but now that long term valuation ratios are available for world markets, it just doesn't make sense to invest in expensive markets even if you are underweight in them.
 

cremeegg

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You should never confuse price with value.
Indeed.

Price is real, value is speculative. (In fact I always bought the stocks which represented better value, but then unfortunately I broke my crystal ball.)

I don't know what the return on the S&P 500 will be in the 10 years from Aug 2018 to Aug 2028. And here is the big secret, neither does anyone else.

I do know that that return will be 1.1% pa better if you buy at 2,500 rather than 2,800.
 

joe sod

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Blowout jobs report in the usa, mumbles from the fed chair about flexibility, Chinese government flexibility re_ their central Bank

European financials and autos were priced for deep recession already, pe of 5 for some of the banks in Europe with BV of half in many cases
looks like a repeat of what happened in january 2016, a terrible autumn with some panic selling around christmas and now a very rapid recovery. When moves happen in the markets they seem to be much more swift than in the past both to the downside and upside.
 

opexlong

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looks like a repeat of what happened in january 2016, a terrible autumn with some panic selling around christmas and now a very rapid recovery. When moves happen in the markets they seem to be much more swift than in the past both to the downside and upside.
Nah. Bear market rally. Look at what's happening in the credit markets and in global stocks.
 
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