Even ‘God’ couldn’t bypass bear markets

It’s easy to feel a bit foolish during a bear market, especially when the “I told you so” brigade point out how you could have protected your portfolio if you’d only followed their advice.

However, the reality is that seriously unpleasant declines are an unavoidable part of the investing process – not even God can steer clear of bear markets.

So says US money manager and Alpha Architect blogger Dr Wesley Gray, who recently asked the question: what if you had perfect foresight, and knew exactly what stocks would deliver the best and worst returns over the next five years? Put another way, could an omnipotent God, Gray wondered, create a hedge fund that was so good that he could never get fired?

God-like returns

To investigate, Gray went all the way back to 1926 and constructed a hypothetical portfolio consisting of the 50 large-cap stocks that would go on to deliver the best returns over the following five years. Every five years, the portfolio would be rebalanced, so that it would only ever consist of the stocks that would go on to become the biggest winners over the next five years.

Unsurprisingly, the results are spectacular, with the portfolio returning 29 per cent annually over eight decades. To put that in perspective, a €1 investment returning 29 per cent over a 90-year period would be worth almost €9 billion today.

However, it would not have been a pain-free ride. Investors in “God’s fund” would have suffered no less than eight different bear markets – declines of at least 20 per cent – as well as two further 19 per cent declines. The worst drawdown would have been between 1929 and 1932, when even the best performers suffered a devastating 76 per cent collapse. God would also have presided over four separate market meltdowns, the losses ranging in severity from 31 to 44 per cent.

Clearly, being long equities – even the very best performers – can be a stressful experience. Perhaps the solution would be to create the perfect hedge fund – that is, to buy what the biggest winners of the future and to sell short (to bet against) the biggest losers?

The “ultimate hedge fund”, Gray found, does “amazingly well”, easily trumping the long-only fund by returning 39 per cent annually. However, the drawdowns tended to be awful, with this apparently perfect portfolio plunging by at least 25 per cent on 10 occasions. On three occasions, it halved in value; the portfolio lost more than one-third of its value on seven occasions.

“Even God would most likely get fired as an active investor,” Gray concluded. “Perfect foresight has great returns, but gut-wrenching drawdowns.”

Messy

Everyone should know that market declines are part and parcel of investing, but it’s easy to underestimate the extent of this unpleasant reality. Look at a long-term chart of history’s biggest winners and you could be forgiven for thinking that it’s one long uptrend punctuated by occasional but irrelevant corrections. In reality, it’s messier than that.

For example, the biggest winner in the US equity market over the last 20 years has been Monster Beverage, which has increased in value by more than 100,000 per cent.

The stock has been hit hard by the recent equity market turmoil, losing more than a quarter of its value since early December. This is not some freak event; as Motley Fool and Wall Street Journal finance columnist Morgan Housel recently noted, the stock has been a "gut-wrenching nightmare to own" for most of the last 20 years. It has halved in price on four occasions and lost more than two-thirds of its value on two occasions. Monster traded below its all-time high on 94 per cent of days. On average, the stock traded at 26 per cent below its previous two-year high.

It is, as Housel noted, “hard to grasp how the best-performing stock of the last 20 years could spend the majority of that time with returns that would make you want to vomit”.

This is not an isolated example. Late last year, Ritholtz Wealth Management director of research Michael Batnick looked at the 10 top-performing stocks of the last decade. All bar one of those 10 stocks had at one stage or another halved in price. One third of the time, they were in individual bear markets, trading at least 20 per cent below their previous highs. Only two of the 10 stocks spent more time at all-time highs than the S&P 500.

No escape

There’s no escaping equity market drawdowns, whether you’re an active investor targeting big gains from volatile growth stocks or a passive investor willing to simply track diversified market indices over time.

Fund giant Vanguard recently noted that the global stock market has endured 12 corrections and seven bear markets over the last 36 years. During that period, stock prices have spent almost 30 per cent of days in corrections or bear markets. Since 1928, Vanguard added, the S&P 500 has spent 40 per cent of its time in a correction or bear market. During that period, it delivered annualised returns of roughly 10 per cent, but only to investors who were willing to stick it out and take the rough with the smooth.

We are, of course, currently in the midst of one such period, with a host of major international indices falling into bear markets in recent months. Anyone with a basic grasp of financial market history might be tempted to say, so what? Isn’t this ultimately pretty normal market behaviour, rather than being some sinister aberration that is indicative of the apocalypse to come?

But for many investors, it may not feel “normal” for two obvious reasons. Firstly, the media likes to sensationalise market falls; “Sell everything” and “Are you prepared for a stock market crash?” make for better headlines than “Stock declines are pretty common”.

Secondly, it’s never pleasant to see your portfolio decline in value. Behavioural economists and psychologists have long documented that most people suffer from an instinctive loss aversion; simply put, the pain of a financial loss is much more keenly felt than an equivalent financial gain.

Research from influential economist Richard Thaler shows that the more people look at their portfolios, the less inclined they are to take on risk. Why? Because the more you check your portfolio, the more likely you are to experience the pain of a financial loss.

“Don’t look” may not appear responsible financial advice, and some investors may be tempted to devise an alternative strategy that delivers good returns in good times and bad. Avoiding periodic portfolio declines is nigh on impossible, however – as Wesley Gray’s research shows, not even God can manage to do so.