Corrections Happen – A Brief History of Down Markets

Most investors know that over most long-term periods, well-diversified stock portfolios have produced more growth than other publicly available investment options.

Fewer investors are aware of the “flip side” of this fact – that short-term drops in stock market values occur quite frequently.

As a result, investors often get unnecessarily nervous when inevitable market declines occur and sell out at the worst possible time - when the market is low.

Even those who resist selling when markets drop often stop investing new money in stocks. These investors risk failing to realize the usually sharp gains that occur during the few months following a decline.

To avoid bad moods when stock markets drop, and to realize the long-term benefits of being invested in the stock market, it is helpful to know a little history.

We often tell clients that though they should invest in stocks to maximize long-term growth, they should also expect that often there will be short periods their stocks won’t grow as much as so-called “safe” investments like certificates of deposits and bonds.

Unfortunately, experts don’t know in advance exactly when these bad periods are going to happen, so we cannot avoid down markets without sacrificing long-term growth potential.   Fortunately, history shows that investors don’t need to avoid short-term declines to secure impressive return on investments from stocks.

In fact, one has to go back to the Great Depression to find a 20-year period that stocks did not grow as fast as short-term government bonds.  Going further back, research tells us that since 1802, stocks have grown faster than such bonds roughly 95% of the 20-calendar year periods.

Obviously, then stocks seem the better option in the long term.  But in the short term, the story is quite different.

Since 1926, the S&P 500 stock index, which measures the performance of roughly 500 of America’s top publicly-traded corporations, has lost value during nearly 30% of the calendar years – that’s 23 of the past 81 years.   During close to half (10) of these years, the decline was 10% or more.

Adding insult to injury, even during the roughly 70% of the time that stocks have grown over the course of a calendar year, the results are not always impressive.  Nearly one-fifth of the time that markets rise (11 out of the past 58 years), stocks grew less than the 10% average.

In short, the common sense notion that stocks grow 10% per year is only true in the long term – over 40% of the past 81 calendar years, stocks have generally not achieved this historic average.

Fortunately, it is possible to stay invested in stocks during down markets and reduce the potential pain.

The most important technique to do so is to diversify across asset classes (e.g. small/mid/large, value/growth, domestic/international), industries (e.g. health care, technology), and companies.

One needs only to study the bear market of 2000-2002 to appreciate the value of diversification.

Prior to 2000, many investors had loaded up on blue chip “growth” stocks like General Electric, Cisco, and Walmart.  During the three calendar years that followed, an indexed portfolio of U.S. blue chip growth stocks (as measured by the Russell 1000 Growth index) dropped over 60%.

During that same bear market period, however, a more diversified portfolio fared much better – large cap U.S. value stocks dropped only 15%, small cap U.S. stocks dropped only 21%, and large cap international stocks dropped 43% — still large, but measurably better than 60% loss suffered by U.S. growth stocks.

It would be nice if history could also accurately predict when stock markets were going to decline, but experience demonstrates that most efforts to time the market end up costing investors more than they gain.

But history can teach us a lot.  Armed with knowledge that “corrections happen”, prudent investors can maintain more peace of mind during declining stock markets.  As a result, they are more likely to avoid turning short-term losses into long-term losses.

In conclusion, being upset when stocks drop is like complaining when it rains outside – though unpleasant, it is an inevitable part of life that is important to manage prudently and not get too upset over.

In this respect, understanding the history of stock markets and the value of diversification is the equivalent of carrying a rain coat and umbrella.  Investors who are not armed with such investment knowledge risk ending up all wet when the weather gets nasty.