Sunday night, John Hussman tweeted out the following;
While Hussman’s funds have had a rough decade he always makes great points including conveying the point in this Tweet. A huge focus of my blogging and more importantly my portfolio management is about trying to avoid the full brunt of large declines.
Large declines are something that market participants have to accept as being reality. After a bull run, the market will go down a lot for about two years (about the historical average) and scare the hell out of a lot of people. Once it stops dropping it will go up and go on to make a new high, with the only variable being how long it takes. I’ve blogged that sentiment more times than I can remember.
My primary hope is that clients will continue to understand this reality, be ready for it ahead of time and not panic when it comes. I learned many years ago during my time at Fisher Investments that fast declines snap back quickly, it is the slow declines that cause more problems.
One clue that a slow decline is unfolding is when the market goes down an average of 2% per month for three months in a row (it doesn’t happen very often). I also heed a breach of the 200 day moving average by the S&P 500 as well as the inverted yield curve. There are some secondary things I look out for as well like a sector becoming disproportionately large in the index.
I have made the above points a couple of times already here at The Maven because it is a crucial part of what I do.
Delving more into the logic with this post ties into to Hussman’s Tweet. If the S&P 500 averages somewhere between 7-10% per year depending on the period you look at, as an average that includes the bear markets. If in the next bear market your defensive action means you only go down 20% or 30% in a down 40% world then you are building in potentially many years of alpha into your long-term result.
If you get back in with great timing, then you might preserve that alpha for a very long time, but I think of it a little differently. You have an opportunity to take a little less risk for a very long time. For someone with an adequate savings rate and who doesn’t do themselves in with a catastrophic behavioral mistake, the 7-10% average return is probably enough to get the job done.
The chart I made is just from using Paint, it looks terrible but makes the point. The black line is the market and the green line is a type of ideal portfolio outcome; equaling the market with zero volatility. The green line is not possible, but it creates context for the concept of smoothing out the ride. Again, with an adequate savings rate, coming close to equaling the market can get the job done and the more you can smooth out the ride the more likely you are to avoid behavioral catastrophes (like panic selling). Behavioral mistakes are far more likely to derail a financial plan than mediocre investment results.