Investing is cyclical in nature. There are periods where fear abounds and others when people throw caution to the wind. Sometimes the market goes nowhere and others times it feels like it’s running away without us.
This cyclical nature of investing can lead to impatience and frustration. And I think we are currently in one of the most frustrating parts of the market cycle for diversified investors—for two reasons.
First, the U.S. stock market is entering the 8th year of the current bull market. As a result, any diversified portfolio will have, without a doubt, failed to keep pace over the period.
But, at the same time over the last 18 months or so, the market has gone nowhere. U.S. Large company stocks have bounced around a lot, but with no progress. Other areas are flat or down over the period—Bonds (AGG) are up just 0.8%, small caps stocks (IWM) are down -2.1%, International stocks (ACWX) down 10.3%. All this adds up to a frustrating period for holders of a diversified portfolio.
Now, neither of these conditions, the length of the current bull market or the prolonged sideways period, necessarily mean the end of a bull market as some want to say. However, as mentioned, it can be a discouraging environment for investors.
So, in this post, I want to address the first area of frustration: the fact that at this point in the market cycle (many years into a bull market rally) there will almost assuredly be a lot of space between your diversified portfolio’s return and the cumulative returns to the equity market index.
Not keeping up can feel painful
Take a look at the chart below which compares the performance of the classic 60/40 portfolio (60% invested in the S&P 500 index and 40% in the Barclays Aggregate bond index) to the performance of the S&P 500 index. Notice that after a multi-year Bull market there is a lot of space between the lines.
The performance gap grows during bull markets, then shrinks as the diversification helps during the next inevitable bear market.
But, you don’t need to keep up
The point I’m trying to get to is that a diversified portfolio (using the simple 60/40 portfolio as an example in this case) does a reasonable job keeping up over a full market cycle even though there are periods, particularly many years into a bull market when the gap is wide.
And the reason this can happen is the asymmetry of how gains and losses compound. This fact is no secret, it’s a mathematical certainty, but it has significant implications on your portfolio.
Newfound Research recently published an article called “The Asymmetry Zone” on the topic. In it, they include the following graphic:
As the graphic shows, the gains required to recover an investment loss are always greater than the initial loss. In the case of a 50% loss, the gain needed to recover the loss is a whopping 100%!
For small losses the gain needed to recover is only slightly larger than the loss. But for significant losses, the gain required to break-even increases exponentially. (See table to the right). While a 50% loss requires a 100% return to break even, increasing the loss to 75% makes the return required triple to 300%, and it just gets worse from there.
So, what can you do to exploit this asymmetry? The first step is clearly to limit your losses.
A diversified portfolio serves to reduce the “capture ratio” of your portfolio compared to an all-stock index. For example, take a portfolio that captures only 75% of the stock market’s performance. Using our prior example, if the market loses 50%, this portfolio will only be down 37.5% (.75 x -50%). Then if the market doubles, instead of only getting back to breakeven, where you would with a 100% capture ratio, you actually come out ahead. The math works out that a 37.5% loss followed by a 75% gain is greater than a 50% loss followed by a 100% gain.
That’s how you can exploit the asymmetry of returns, and it’s a major benefit of limiting losses through diversification.
What it means now
Since the March 2009 market lows, the S&P 500 index is up an astounding 227% compared to 136% for the 60/40 portfolio. This gap is a source of frustration for some.
However, according to JP Morgan’s research, the average bear market drop since 1929 is 45%.
Using the 60/40 portfolio and assuming a capture ratio of 55% (the average capture over the last two bear markets), a market correction of 45% would mean the 60/40 portfolio and the S&P 500 index are essentially back to the same level.
We’re at the point in the market cycle where it’s getting frustrating for people who haven’t kept up with the bull market. But it’s important to remember why that is: for most people, holding a diversified portfolio is a much more likely strategy to achieving your goals than simply being 100% invested in the stock market. And remember, through the magic of compounded gains and return asymmetry, you don’t need to keep up with the market during a bull market to keep up over a full market cycle. Limiting your upside and similarly limiting your downside is a successful combination.
Price returns from 12/1/2014 – 04/30/2016 via Yahoo Finance.