As we write this note today, the market is having its first hiccup of the New Year, not to mention its first hiccup in what feels like many weeks. The S&P is down nearly 3% for the month, which of course invites incredible amount of teeth-gnashing. This weekend, we’ll hear from everyone that world markets are going to Hades and back and that social unrest is right around the corner. Ok, that’s a bit of an exaggeration, but suffice to say there are a number of people running around with the heads on fire and their rear-ends catching because there’s red on the screens. Considering investors experienced a somewhat unusual year last year with 30%+ returns and amazingly low volatility, it comes as no surprise that investors are jolted by some cold water to the face.
We planned on undertaking this exercise anyway, but it becomes more interesting on a down nearly 2% day for sure. Using simple statistics, it’s interesting to look at yearly and monthly S&P 500 returns and get a glimpse of how much randomness and variance/volatility actually occur through time. Our minds tend to conveniently ignore these facts, especially after outstanding years like 2013. Over time, though, we all need reminders that outcomes like the start to this month and year are actually relatively high probability events. The current month isn’t exceptional (at least not yet). Let’s get to the wonkish work.
We looked at yearly S&P 500 total returns (price change + dividends) going back to 1931 as well as monthly returns (just price change) over that time period. The simple statistics are quite interesting for sure.
Let’s start with the yearly numbers.
Average total return for the S&P 500 over that 83-year period is 11.81%. Standard deviation for that set of returns is 19.31%. Under a normal bell-curve, approximately 50% of outcomes should fall between +0.674 and -0.674 standard deviations from the average. 95% of outcomes should occur between -1.96 and +1.96 standard deviations from the average. We know that markets have slightly “fatter tails” than typically expected under a normal bell curve, so we made a few minor adjustments to account for this fact. After those adjustments, we find that the 50% range for yearly market performance outcomes is between 24.9% and -1.28%. 60% of outcomes should fall between 31.94% and -8.33%. Therefore, there’s a decent probability in any given year that S&P 500 returns can fall in a pretty wide range. Let’s say the market doesn’t move much from today’s close and finishes down 3%. Statistically, that wouldn’t be that phenomenal of an event, though pundits and analysts would tell you it feels like the end of civilization. Returns like that would be frustrating after such a strong run of performance years, but nothing that shouldn’t be expected having participated in the markets for a while. And remember, 50% of yearly returns should fall outside of 24.9% on the upside or -1.28% on the downside. Let’s expand the probability range, if you will, out to 95%. That range is +50.23% to -26.03%. Beyond those values, we see the monster tail events that are talked about for eons and eons. Sure enough, there are 5 years total that fall in the extreme tails (6% of outcomes, close to the 5% that should occur in the extreme tails), 3 down, 2 up. The three extremely negative years are 1931, 2008, and 1937. The two monster up years were 1933 and 1954. Of note, 1974 came very close to joining the others, down 26.00%. Basically, years like this should, up or down, should occur once every 20 years on average.
Now, let’s look at the monthly numbers.
Average monthly return over the past 83 years is 0.59%, with a standard deviation of 5.43%. Like the yearly numbers above, we can quickly calculate the probability ranges for monthly outcomes. 50% of outcomes should fall between 4.25% and -3.08%, again a pretty wide range, at least relative to many investors’ expectations. Accordingly, 50% should fall outside of that range, up and down, over time. As of today’s close, the S&P 500 is down 3.04%, which actually falls within the 50% range. It’s painful, yes, but nothing to write home about in the long history of US markets. Think about this. If we’d written at the end of 2013 that half of the months during 2014 could come in either above 4.25% or below -3.08%, many off the top of their heads would call us crazy. Yet, statistically, this isn’t necessarily a crazy notion at all. Certainly, markets and data sets aren’t that clean. The point remains, however: market movements are more random and violent than our heads perceive them to be. By the way, what is extreme on a monthly basis? The 95% range is 11.23% to -10.06%. Out of 1007 months, 45 months fall outside of this range, 4.5% of the outcomes. Again, this is close to what we should expect in the extreme tails. A negative 10% month or worse is something to write home about. Fortunately, we haven’t witnessed one since early 2009 when markets were tanking and scaring the wits out of everyone.
Moving beyond the numbers, there are several takeaways we can pull from this analysis.
First, equity markets deliver solid returns over long periods of time, but deliver a decent amount of volatility in return. As hard as it is, expectations for institutional and individual investors must be set accordingly; otherwise poor decisions detrimental to performance are made.
Speaking of too much noise and poor decisions, much of this industry, especially the financial media, is geared towards encouraging professionals and individuals to trade or react around market moves that in retrospect are rather unexceptional and “to be expected”. On a down 2% day, there’ll be no shortage of serious banter on CNBC about the end of markets. Stock selection “lightning rounds” will be particularly electric. Study after study shows that investors are terrible short to intermediate-term market timers, even those with teams of analysts and expensive market analysis tools at their disposal. For nearly all investors, spinning one’s wheels to turn, let’s say, a 3% monthly decline or an 8% yearly decline into a positive month or year, will probably do much more harm than good in the end.
Instead of worrying about the 2% or 3% or 5% down months, or the 0% to -10% down years, it behooves all to think more about protecting against the yearly massive tail events, i.e. the 1974s, the 2008s, and the 1931s of the world. Those provide the most devastating shocks to long-term portfolio performance. This, of course, is easier said than done though, believe it or not, chopping off a portion of these tail events can be accomplished through many different methodologies. Many institutions have produced models successful in identifying situations during which probabilities are high for serious, bone-crushing bear markets. Many market professionals, for instance, anticipated the events of 2008/2009. For individuals, perhaps taming the volatility dragon involves employing a strategy like a 60/40 equity/bond model or employing some of the simple hedging ETFs out there as a small portion of a portfolio.
In any case, this brings us to our final point, one mentioned last week as well. Institutional and individual investors alike should have a process or plan and stick to it, as hard as that is under many circumstances. Whether a technical trading risk or rebalancing or dollar cost averaging system or long-term investor plan/statement, having a solid plan in place allows one to ignore noise during months like these that fall in the typical range and avoid execution errors that occur time and time again. There’s no shortage of people that bought the hype and bought “growth” stocks and funds at the 2000 internet peak, nor is there a shortage of investors that dumped every asset under the sun at or near the very lows in March 2009, only to keep piles of cash on hand as markets doubled or more around the globe. Shooting from the hip and making decisions based upon news mentioned in the financial press, or on TV, or in analyst research reports is a recipe for poor long-term outcomes.
The statistics above show us that performance noise is a part of the month-to-month and year-to-year existence of an equity market investor. It’s always surprising to see how noisy “normal” truly is. Letting noise affect decision-making, a common problem for us humans, is the biggest problem in the markets. If investors spent more time creating objective intermediate to long-term investment plans and processes, and less worrying about what is happening in X or Y country around the world or in Washington DC, outcomes would improve significantly.
