The past few months have been a turbulent period for investors, with sharemarkets worldwide registering steep declines and experiencing significant volatility.
At times like this, it can be tempting to consider abandoning your investment strategy, selling down to limit your losses and then aiming to buy back in once things “have settled down”.
We know from history, however, that this approach is seldom optimal and that investors who manage to hold their nerve during difficult periods like these are usually rewarded over the longer term.
While we’ve previously outlined some tips for surviving market falls, we thought it would be useful to look back at some market history. While past performance obviously can’t guarantee how things will pan out in the ensuing months, it can help put the current market downturn in context.
The chart below tracks the performance of the ASX200 index over the past 26 years (i.e. as far back as our ASX200 data goes). The S&P/ASX200 has been the main benchmark for Australian sharemarket since early 2000 but the underlying index extends back to 1992. During this time, the Australian sharemarket has generally trended upwards, growing by an average 5.5% per annum.
Of course, the trend has hardly been smooth and consistent, with periods of significant declines seen particularly around the GFC in 2007-08, the Internet technology bubble of the late 1990s and the European debt crisis of 2011. And while the ASX200 has posted an overall average monthly gain of 0.46%, more than 40% of all monthly returns have been negative, and across those down-months, the average fall was around ‑3.2%. (The optimists amongst us would equally highlight that 60% of all monthly returns have been positive!)
When the ASX200 has declined, those falls have tended to be relatively short-lived. In most cases (89% of all down-months), the declines have lasted 1-3 months before the market has rallied. There have only been three instances (during the GFC and 2011) when the market has declined for six consecutive months.
One of the main takeaways from this data is that market volatility – just like we are experiencing now - is (unfortunately) a normal and unavoidable part of investing. Markets invariably have periods of weakness, but also tend to recover relatively quickly (albeit in an unpredictable manner). Over the longer term, history shows that markets generally trend upwards and provide long-term returns to those investors who are disciplined and patient enough to ride out the inevitable market fluctuations.
To this end, it is worth remembering that price changes are only one part of the picture. Dividends are, of course, another major source of sharemarket gains and can often provide a useful buffer against price declines. The chart below shows the same historical ASX200 data but also overlays the impact of dividends (which are assumed to be reinvested back into the market rather than kept in cash).
With dividends included, the ASX200’s performance has remained similarly volatile, but overall annual returns have been closer to 10% each year. The recovery from the GFC downturn in 2007-08 has also been more significant. This is partly due to the compounding effect of dividends having been reinvested when share prices have fallen (which ultimately enhances returns as prices eventually recover).
While the recent market downturn has been steep, it is not unprecedented in a historical context. As you can see below, October’s ASX200 decline of -6.1% was around twice the average decline in a typical down month but only ranks as the 17th worst down-month over the past 26 years. This is well below the sharpest declines seen during the GFC (eg. the ASX200 fell -13% in October 2008 and -11% in January 2008).
As we often emphasise, trying to move in and out of markets and/or pick a market top or bottom is exceptionally difficult. It is so challenging that even professional portfolio managers seldom get this right on a consistent and repeatable basis. As a result, it's usually counter-productive to jump out of the market (especially after a steep sell-off) and then wait for markets to “stabilise” before climbing back in.
One of the main reasons for this is that the best and worst trading days usually happen close together and are nearly impossible to identify ahead of time. As a result, if you get your timing wrong (as is most likely the case), then you run the risk of significantly hampering your returns in two ways – firstly by locking in your losses and secondly by missing out on the eventual market recovery when it occurs.
To illustrate this example, we looked at the ASX200’s 15th worst monthly falls over the past 26 years and what happened in the ensuing periods. While there was obviously reasonably wide variability in experiences (as one would expect), in 80% of cases, an investor who held onto their exposure after these sharp declines would have more than recovered his/her losses within 1 year (i.e. the median gain 12 months after the down-month was +11%). After three years, the median total return would have been +35% and by year 5, it would have risen to +63%.
If, instead, an investor had sold down immediately after the down-month and then only reinvested after the markets had started to recover, he/she would have been far worse off.
For the purposes of the exercise, we assumed that an investor seeking to time the market would only re-enter the market once the ASX200 had recorded at least one month of positive returns (i.e. indicating signs of a market recovery). This typically would have occurred two months after the down-month but varied from one to six months across the 15 worst down-month events.
An investor who sought to time the market in this manner would typically have made no gains after the one-year point (median return of 0%) and would be up only 28% after three years (compared with the 35% with no sell-down) and 48% after five years (compared with 63%). While this is admittedly an extreme and simplistic example, it demonstrates the downsides of trying to time the markets.
So, what are the key takeaways as we consider market cycles?
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The commentary in this article is general advice only. It has been prepared without considering your objectives, financial situation or needs. It is no substitute for financial advice. Where quoted, past performance is not indicative of future performance and may not be repeated.