Investors by the millions were startled -- many were shocked -- by the market's sudden plunge in the spring of 2006. In this article, Paul Merriman uses data back to 1970 to show that losing money, at least temporarily, is a sure thing.

Wall Street loves to lure you with how much money you’ll make, how secure you’ll be, how life will be endless bliss if you just accept their solutions and services. That’s a mighty marketing message, one we’d all like to buy into. But in real life we all know better – or at least we should know better.

I’m known for telling it like it is, and I’ll start this article with some bad news you don’t want to hear: If you invest in stocks, either directly or through mutual funds, you will sometimes lose money. This is not a possibility. It’s a certainty.

In fact, I promise it. If you invest in equities and you never lose a dime in the market, please hire a lawyer and sue me for breach of promise. I’d love to learn how you did it.

Even if you eventually sell at a profit, as we all want to do, there will be down periods in which you will lose money. If you were invested in the market in May and June this year, you almost certainly lost some money.  

After three years of strong recovery from the awful bear market of 2000-2002, many people started acting as if the market could go nowhere but up. Then, without warning, along came a sudden correction that in four weeks wiped out most if not all gains from the previous four months.

Welcome back to the real world!

FEELING THE PAIN

What happened this spring is perfectly normal market behavior. It’s called a drawdown, a drop in market value that is presumably temporary. You’re probably familiar with graphs that show investment returns over time, with the lines sometimes going up and sometimes going down. Drawdowns represent the lines that go down.

Drawdowns are illustrated in Table 1. It shows, for every calendar year 1970 through 2005, the worst drawdown experienced in each of 11 managed investment portfolios plus the Standard & Poor's 500 Index.

For a larger, printable version of this table, click here.

For this table, a drawdown is defined as a drop in market value from the start of any month to the end of that month or any subsequent month. A drawdown occurs only when the portfolio fails to recover to its starting value.

The table is necessarily flawed because it is based on monthly data, not daily data. For example, if your portfolio fell from $100,000 on September 1 to $92,000 on September 30, the drawdown would be 8 percent. On the other hand, if your portfolio fell to $92,000 by September 20 but then recovered to $100,000 by September 30, that temporary loss would not be counted as a drawdown for the purposes of this table.

Even with that limitation, this table shows investors what they must be prepared for if they invest in the equity market. The bottom line of each column shows the average of the worst annual drawdowns; as you’d expect, the pain increased along with the proportion of equities.

The performance of each portfolio except the Standard & Poor's 500 Index is based on data from Dimensional Fund Advisors; some of it is indexes and some is from actual fund results. The fixed-income portion is dominated by short-term bonds. Equity portions include equal parts of U.S. and international funds as well as approximately equal allocations of large and small and value and growth. All results in the table from these portfolios assume payment of a 1 percent annual management fee.

Also note: Without exception, every year of every equity portfolio included drawdowns. (The fixed-income portfolio had eight drawdown-free years; but it also had two years with losses of more than 4 percent.)

Looking down the table year by year, here are a few things I noticed:

•    1970 was a pretty painful year if you had 50 percent or more equity exposure.
•    1974 was the worst year for equity investors; at one point the S&P 500 Index lost nearly one-third of its value.
•    1977 was bad for fixed-income and S&P 500 Index investors, but diversified portfolios produced only a pittance of pain.
•     1984 was the worst year for the diversified portfolios.
•    1987 in the table looks very painful (as it was in real life), but full-year results (not shown here) were quite positive for diversified portfolios. The 50 percent portfolio gained 11.8 percent that year, the 60 percent portfolio was up 13.3 percent and the all-equity diversified portfolio gained 18.2 percent. The S&P 500 Index was up 5.2 percent. As this illustrates, drawdowns show the pain but not necessarily the whole story.
•    1994 gave investors nowhere to hide from losses.
•    1998 was very painful for diversified investors but drawdown-free for the fixed-income portfolio.
•    2003, 2004 and 2005 had worst drawdowns that were much lower than average.

If you look only at averages (the bottom line), you may get a false sense of security. They are mathematically accurate – but can be misleading. For example, a temporary loss of 4.2 percent, as shown for the 50 percent equity portfolio, shouldn’t be too hard for many investors to stomach. But that average includes three double-digit losses plus three others of 9 percent or more.



For a larger, printable version of this table, click here

In Table 2, you’ll see how the May-June drawdowns of 2006 stacked up against these annual averages. You’ll see that by and large, this spring’s drawdown was  reasonably close to average. The notable exception was the Standard & Poor's 500 Index, which held up better than the diversified portfolios with small, value and international funds.

WHAT’S AVERAGE?

One other observation about averages: You might not ever find them in real life. I looked in vain for any calendar year that looked like “an average year.” The closest I could find was 1981, and it’s not very close when it comes to the portfolios with higher percentages of equity.

The overriding lesson I take away from this table is that short-term pains are inevitable on the road to long-term gains.

The market tumult this spring is well within the range of normal, though it’s easy to see how the mild drawdowns of the past three calendar years could make investors too comfortable.

Those who were hit by panic should treat this as a wake-up call and re-evaluate how much risk they are taking. That, of course, is best done in calmer times. When push comes to shove, as Mark Hulbert has observed, emotions always seem to trump reason.

Back in the spring of 2000, as the market began to tumble from its all-time highs into what would become a severe bear market lasting two and a half years, many investors were thrown into panic. This was right on the heels of a year (1999) in which more than 100 mutual funds had triple-digit returns. Investing looked easy!

WISDOM FROM THE PAST

But by April 2000, we were into serious bear-market territory, with the Nasdaq down 18 percent, the Dow Jones Industrial Average down 10.4 percent and 85 percent of all equity funds in the red for the year. Many investors were shocked to get their first real taste of the pain that the market can dish up.

In that month we wrote a letter to our clients, and I think it’s worth quoting from that letter now as a reminder of how to handle tough times.

Here is some of what we wrote:

“What’s an investor to do? The correct answer is very short: Develop a good strategy and follow it. You hired us to help you do that, and that’s what we’re doing. …

“On their Web site, our friends over at Safeco Mutual Funds recently summed up the current situation very well in a few words: “Trying to get rich quick is dangerous business. So is giving up too easily.” If you follow the advice implied by those sentences, you will be on the right track. …

“The reversals of the past five weeks have been extremely unnerving to many investors, especially those who got caught in the euphoria of early March and … apparently decided that caution was an outdated concept they could afford to ignore. …

“Technology is profoundly changing the world in which we live. And it has produced some spectacular investment opportunities in the past decade. But technology has not repealed the basic rules of successful investing.

“One rule that has not been repealed is diversification. Investors who properly diversify do not have to worry very much about short-term changes in a single sector.

“Another rule still in effect is that if you want to be a successful investor, it is mandatory to persevere in periods like these. I’ve worked hard to make sure all our clients understand that, but I fear some people perhaps don’t want to hear it. So let me say it another way: If you can’t successfully get through periods like this, you have little chance of being a successful long-term investor.

“I’d like to repeat something else I wrote to our clients in 1998, because it’s just as true now as it was then:

‘In the very good times, it seems as if investing is about accepting wealth. You put down your money, almost like planting it in a garden, and watch it grow. But in fact, in good times and bad, investing is really about managing risk and managing your emotions. If you want to be a successful investor, you’ve got to do at least a decent job at both those tasks.’

“If I could tape that paragraph onto the front of your refrigerator, I’d do it! … Volatility is a fact of life, and investors who pretend otherwise usually live to regret it. …

“One excellent place to start managing the emotional side of investing is to focus on appropriate time periods. Some people seem to think that long-term investing means waiting three weeks to decide if they made a good choice. Others become anxious if an investment doesn’t go up the day after they bought it. So here are two quick tips about time and investing:
•    If you will need to withdraw money for something like a down payment on a house or a year of college tuition within the next 12 months, get that money out of the stock market.
•    If your goal is achieving results in five years or 10 or 20, don’t measure and judge your success every day, every week, every month or even every quarter. Judge your performance over a period longer than a single year. …

“This is one of those periods that let investors discover whether they have taken on too much risk. To find out for yourself, take our simple risk-evaluation test by asking yourself three questions.
 
•    Have you lost any sleep over your investments?
•    Do you feel compelled to watch the financial news and check fund prices daily or weekly? (We are talking about feeling compelled, not just curious.)
•    Does the financial news make you worry about your future?

"If your answer to any one of those questions is affirmative, you may have taken on too much risk. If you answer yes to all three, your investments are definitely too risky for you.”

RISK NEVER ENDS

No matter how many letters we send, no matter how well we teach people to manage their emotions, dealing with risk is a never-ending job. It's not normal to see month after month of gains without some setbacks along the way.

There’s no reliable way to know just how widespread panic is among investors. In my experience, a relative handful of individuals are vocally anxious. But as a result, sometimes the media tries to depict a feeding frenzy of fear. This of course is self-serving, giving newspapers, magazines and newsletters a way to promote themselves and get people excited. (After all, magazine covers can get pretty boring when all the news is good.)

Conversations with several of our company’s financial advisors suggest to me that most investors apparently tolerated the latest market upheaval fairly well.

Aaron Spencer said only three of his approximately 200 clients called him about the downturn. Cheryl Curran said only about 1 to 2 percent of her clients called her with emotional reactions to their losses.

Tyler Bartlett, another financial advisor, said all his clients lost money this spring. But only one called to discuss it, and Tyler used that opportunity to revisit the person’s risk tolerance.

Jim Whipps said the suddenness of the correction felt like a cold slap in the face to some clients who had been elated for the previous four months. His advice: Trust the strategy and wait until the market corrects itself. This is not the time to bail out.

A conversation I had with a client illustrates a mental trap many people fall into. They plan for risk in terms of percentages but react to it in terms of dollars. Here’s what I mean: The client and his wife were upset that they had lost about 7 percent of their retirement portfolio from the peak, even though that was well within the range of risk they had agreed they could accept when they opened their account with about $1 million early this year.

He was upset about losing $70,000. “I could have bought a very nice new car for that,” he said. His wife told me they could have bought a college education for their grandson with that money. And now it was gone.

All that’s true, of course. But calculating your losses that way can hook your emotions and lead you astray. (It’s equally mischievous, when the market is going up, to start counting new purchases you can make with your gains.)

“I gave you this money to protect it,” this client said. I pointed out that his investments had held up better than if he had left that money where it was previously and that it had done better than the market as a whole.

This couple didn’t bail out, but they are still mighty uncomfortable, partly because this drawdown occurred shortly after they had adopted their current strategy. I’ve observed over the years that initial performance, in other words what happens to an investment shortly after investors commit to it, has a strong influence on how much they will trust it.

If a stock or a fund or a portfolio goes up right away, an investor often forms an emotional bond with it and trusts it. That bond will often lead investors to stick with their investments through thick and thin. On the other hand, if the initial performance is negative, some investors find it very easy to ditch an investment in disillusion.


At least one good thing resulted from this market correction. Many people realized that the charts we’ve been showing them for years (Table 1 on Page 2 is a good example) aren’t just theoretical.

Real people experience real losses in real time, and there is no way to avoid it.

TIMELESS TRUTHS

In April 2006, a few weeks before the correction began, Babson Capital Management in Boston, which publishes one of the oldest investment newsletters in the country, came out with an issue that highlighted “five essential truths” that most investment veterans would find easy to endorse. Here they are, slightly paraphrased:

1.    Markets are unpredictable and ill-suited to forecasts.
2.    Long-term fundamentals hold the key to investment success.
3.    Market volatility is a product of investors’ emotions.
4.    Discipline should guide investment selection.
5.    The market rewards perspective and patience.

Here are some excerpts from that newsletter that I think are worth repeating.

“Many things simply cannot be accurately predicted by anyone, no matter how informed or knowledgeable he is. … Most of the predictions made a year ago were so wide of the mark that economists have stopped releasing their detailed forecasts. …

“At times, the majority of investors seem to believe the whole future is wrapped up in the headlines of the day. … No longer do stocks slump gradually as investors ponder the significance of news. Instead of ready, aim, fire, it’s just fire! …
 
“Stock prices swing up and down primarily because investor attitudes change from optimism to pessimism and back again. … In our view the best way to cope with short-term problems and  uncertainties is to ignore them as much as possible. …

“At the highs and lows of the market, the prevailing mood almost always turns out to be wrong. … When the bandwagon is rolling down the street, everyone wants to climb aboard. … When everyone is bailing out because the current picture is gloomy, that may be the time to be a buyer, not a seller. …

“No particular investment approach works well every single year.”

I think the last quote is particularly worth remembering. As you can see in Table 1, every year is different. And every year, investors are tested.

The past three calendar years were very comfortable. But investors don’t get paid to be comfortable. They get paid to take risks, and risks necessarily include periods of losing money. Exposing yourself to risk is the only way to achieve a return that will meaningfully beat inflation.

As I said in that letter to clients six years ago, if you want to be a successful investor, you have two important jobs. One is managing your risks. The other is managing your emotions.