What It Takes to Be an Equity Investor

According to Wall Street lore, an alert young man who found himself in the presence of J.P. Morgan seized the moment and asked for the legendary man’s opinion on the future of the stock market. Morgan’s alleged reply was prophetic indeed.  He said, “Young man, I believe the market is going to fluctuate.”

It did, it always has and it always will.

Ironically, eleven years to the day that the stock market bottomed at the crescendo of the 2008-2009 financial crisis, we’re on the precipice of another bear market. The average annual drawdown for equities over the last 40 years has been about 14%. As of March 9, the 2020 year-to-date S&P 500 return (excluding dividends) and the intra-year decline were 15% and 19%, respectively.

Based on historical frequency, we’ve been statistically overdue for a bear market—a stock market decline of at least 20%.  Between 1947 and 2019, the S&P 500 had 10 such declines, about one every seven years, with an average peak-to-trough decline of 35% and lasting an average of 536 days.

Statistically, the average person will experience six bear markets in a 40-year working career and four more in a 30-year retirement, but rational equity investors should be willing to ride out those declines.  Why?  Because after each temporary decline, the equity market resumes its permanent advance of both values and dividends.

Volatility in perspective

The stock market has historically offered stellar long-term returns—two to three times higher than those of bonds, after adjusting for inflation.  And the reason why stocks offer superior long-term returns is precisely because it is impossible to forecast what they will do in the short run.

The price of admission to earn these high long-term returns is volatility—the market’s oftentimes gut-wrenching gyrations in reaction to whatever happens to be the apocalypse of the day, along with a ceaseless torrent of unpredictable outcomes.

An investor who is able to ride out the rough spots doesn’t pay this bill in dollars, but there is a very real mental tax.  And not everyone is willing to pay the price, which is why there is an opportunity for those who are.  The bumpy ride is the reason for the higher returns.

The acid test of temperament

The thing in this world that markets hate and fear the most is uncertainty.  We have no control over the uncertainty, but we can and should have perfect control over how we respond to it.

The biggest challenge that investors face, therefore, is one of temperament.  In fact, this is the acid test for a successful equity investor:  You have to be able to ride out both 14% average annual peak-to-trough declines and temporary bear market declines of about a third of your portfolio value every seven years or so.  The overwhelming majority of investors simply can’t do it.  Why not?

When evaluating financial risk and reward with regard to investments, most people seem to abandon the common economic sense of buying low and selling high.  Instead of acting in this rational countercyclical fashion, they climb on the bandwagon when the market rises, buying more and more.  Then, when the market inevitably collapses, they flee, selling out of fear instead of taking advantage of the low prices.

This procyclical behavior toward investments seems to be evolutionally hard-wired into human nature, but the consequences of such self-inflicted behavioral wounds are profound.

During the last 11 years, the S&P 500 had a 16.8% annual total return, including reinvested dividends. But if you missed only the 20 best performance days in this entire bull run, your average annual total return would have been chopped almost exactly in half to 8.5% per year.  (Source:  By The Numbers)

The real risk for equity investors

The problem that we face as investors is that we are human—meaning we are emotional.  And the real risk for equity investors is not volatility; it’s their emotional response to volatility.  We all have an innate tendency to interpret large temporary declines in the market as the beginning of the end.  And when we panic, we flee.  Investor behavior—not investment performance—drives the financial outcomes experienced by most investors.

So during periods of market volatility, what should an investor do?  Keep market volatility in perspective, focus on longer time horizons (decades), and maintain portfolio discipline.  That’s it.  Unfortunately, in practice, this is exceedingly difficult for the average person to do.

When it comes to the stock market, the words of author Adam Smith in “The Money Game” ring very true:  “If you don’t know who you are, this is an expensive place to find out.”