What a difference a year can make. At the beginning of 2016, with the stock market off to its worst six week start ever, I found myself addressing the concerns of clients questioning if they should reduce their ownership of the great companies of the world. Less than a year later, with the market making new highs, clients were suddenly asking me if they should have more of their portfolio invested in stocks. When I get a flurry of questions from clients wondering if they should increase their allocation to the great companies of the world, I find the need to remind everyone that risk and return are joined at the hip. We must always be aware that the permanent uptrend in stocks will inevitably be interrupted by stunning temporary declines.
There is a reason cruise ships hold a lifeboat drill the first few hours into a cruise. The time to prepare is when we are calm and collected. From time to time I also prepare my clients for inevitable storms – storms that come in the form of temporary declines in their stock portfolios. I usually try to do this when they expect nothing but smooth sailing ahead. I do so because it is crucial that my clients keep their heads when the next startling decline comes (notice I did not say “if”).
If we invest in equities because they have historically provided investors with premium returns, we must live with the “premium” volatility they come with. Specifically, investors must be at peace with the fact that historically, the average annual intra-year decline of the broad US stock market has been 14%. One year in three they are treated to a temporary decline of 15% to 20%. If that is not enough, they have enjoyed a “Bear Market”– a temporary decline of at least 20% (though the average is around 30%) – one year in five.
It is easy to forget about this premium fluctuation when we experience a market environment like we have recently. But let me remind you it is no laughing matter to see one-third of your portfolio seemingly disappear during a typical bear market. That is why I constantly remind my clients that this is the tradeoff for the higher returns stocks have historically provided over their lifetimes. I think it keeps them rational when the market does not appear to be.
Successful investing is all about perspective. The primary trend is always higher. But the primary trend does have a propensity to be interrupted temporarily. That is the whole point. The declines are always temporary. The gains are permanent. Remind yourself of that now while the market makes new highs, and don’t forget it the next time the market “surprises” everyone with a perfectly normal temporary decline!
Past performance is not indicative of the future. Nobody knows what returns will be in the future. Having said that, I suspect that the great companies of the world will provide the “premium” returns they have in the past, and investors will also experience “premium” fluctuation of those returns. Premium returns and premium fluctuation will continue to be opposite sides of the same coin.