- Stock prices reflect investor's expectations
about future profits and risk.
When those expectations change as they do frequently,
prices change and they can change dramatically.
Volatile stock prices do not mean that the market
is broken or that the world is ending.
Sharp price declines are expected from time to time
in an efficient stock market.
And their inevitability should be
built in to every investment plan.
I think that most people understand this.
But there's a problem, every market drop feels different.
There is always a narrative and the narrative
is often scarier than the drop itself.
If we can understand the power of a compelling narrative
to make us behave irrationally, we might be better equipped
to make better decisions and feel less anxious
when the stock market does decline.
I'm Ben Felix Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you how to keep your head dow
and stay invested, even if this time is different.
(upbeat music)
To get through periods of market volatility,
I think that we need two pieces of mental equipment.
We need to understand how we as humans are wired to behave
and we need to understand what the data say
about market drops.
Being aware of both the data and the impact
that narratives can have on our behavior
should help us make more rational decisions.
In Robert Shiller's 2017 paper, "Narrative economics",
he explains "Narratives are human constructs
that are mixtures of fact and emotion
and human interest and other extraneous detail
that form an impression on the human mind."
Narratives can be extremely powerful.
Through the framing effect they can change
the way that we see facts.
And through the representativeness bias
they can cause us to ignore base rate probabilities
while drawing parallels between our current situation
and familiar narratives.
A narrative does not change the facts of a situation
but it can easily change how people respond to the facts.
It's important to remember where this information
is coming from.
Robert Shiller is the Yale Economist
who won the 2013 Nobel prize in economic sciences
for his work on bubbles in asset prices.
Schiller defines a bubble as a social epidemic
that involves extravagant expectations about the future.
It is not hard to see the connection between narratives
and their potential effect on asset prices
and the economy as a whole.
Schiller explains that narratives may have played a role
in some of the biggest economic events of modern history.
For example, in the 1920 to 1921 US recession
the narratives were grounded in terrible recent events.
World War I had ended 14 months prior,
the effect of the 1918 influenza pandemic
were still lingering,
the US had been dealing with race riots
and a public fear of communism was growing.
Combined these are the basis for an unsettling
narrative of economic uncertainty.
To top all of that off, US oil prices jumped 50%
between mid 1919 and the end of 1920.
The dominant oil narrative was that
the demand for oil was outstripping supply
due to the increasing uptake of automobiles.
The nation's oil supply was expected
to be depleted within 18 years.
Looking back now, we know that didn't happen
because we found more oil.
Bt you can imagine how that narrative might've affected
expectations about the future at the time.
Based on how the world looks right now
the influenza pandemic of 1918 is particularly interesting.
We don't know what the exact economic impact was
but a 2007 paper from the Federal Reserve Bank of St.Louis
aptly titled "Economic Effects of the 1918
Influenza pandemic: Implications for a Modern-Day Pandemic"
offer some insight.
The 1918 flu is estimated to have killed 675,000 people
in the United States and 40 million people around the world.
From the spring of 1918 through the spring of 1919.
Males aged 18 to 40 were hit the hardest.
Between the sparse available economic data
and anecdotal evidence from newspapers,
we can estimate that the major economic impacts
were a reduction in labor supply,
resulting in a higher cost of labor
and short-term, but substantial revenue reductions
for businesses, particularly in retail and entertainment.
We cannot say with certainty if the recession that followed
was caused by the flu or the confluence of other factors
but we do know that the S&P 500 cyclically adjusted
price earnings ratio dropped to its lowest level in history
in December of 1920, that would have hurt.
But guess what happened next?
Asset prices came screaming back up.
To be fair they did fall sharply again in 1929,
but guess what?
They rebounded again afterward, although
a bit more slowly the second time.
You might be thinking that's a
clear case of survivorship bias.
We can't assume that all market crashes
will be followed by rebounds, just because
that's what we've seen in the US.
Well, do I have news for you?
The phenomenon of markets bouncing back after crashes
was studied by William Goetzmann and Dasol Kim in a 2017
paper titled "Negative Bubbles: What happens after a crash".
They studied stock market crashes
from 101 global stock markets from 1692 to 2015
and identified 1032 events where a market declined
by more than 50% over a 12 month period.
They found that the probability of a large positive return
was higher following a crash.
They note that following a crash investors tend
to decrease their allocation to stocks,
but based on the empirical data supporting rebounds
after crashes, reducing your equity allocation
after a crash might be the worst thing that you can do.
Remember this large empirical data set
is immune to any narratives when we observe it.
Each of those 1032 crashes were probably accompanied
by intimidating reasons to expect worse things to come.
But we can step back and observe the outcomes
free from the accompany narratives.
Knowing that the data on market crashes
going back to 1692 suggest that sharp declines
are usually followed by large positive returns,
we as investors have some challenging decisions
to make during times of market turbulence.
If we get out of the market to avoid a drop
we also need to get back in.
Getting back in at the wrong time might mean
missing out on the rebound gains.
Take the S&P 500, going back to 1926
through the end of February, 2020, as an example.
It had a compound average annual return of 10.08%
in US dollar terms over the full period.
If we remove the top 10 monthly returns,
that's the top 0.9% of months in the full period,
the annualized return drops down to 7.74%
but here's the tricky part.
Most of those top returning months occur
during or after big draw downs.
If you got out, you probably missed out.
If the alternatives were the chance of missing out
on some of the best monthly returns by timing the market
or losing all of your money permanently I could see
how the timing the market wouldn't seem so bad
but let's think for a moment about the concept
of losing all of your money in stocks.
When you buy stocks, you're buying ownership
of expected future earnings from real businesses.
You pay a price for those earnings
based on how risky the businesses are.
When stock prices drop it means that
expected future earnings have decreased
businesses are riskier or some combination.
To lose all of your money in a globally
diversified portfolio of stock index funds,
we would need to be in a situation where nobody expects
any business to earn any profits in the future.
This is an extreme case, and it does seem fairly unlikely.
A more realistic set of alternatives
might be the chance of missing out
on some of the best months by trying
to time the market or having to watch your portfolio
decline for a period of time.
This is where narratives and asset allocation
become equally important.
Narratives will make us believe that this time is different
and the narrative might be different,
but challenging and uncertain times are nothing new.
Just this century and it's still young century,
we've seen the "dotcom" crash,
the "911 attack" on the world trade center, Ebola,
the swine flu, SARS, the global financial crisis,
and the start of COVID-19.
Over this time period, the MSEI all country world index
delivered an average annual compound return
from January, 2000 through February, 2020
of 6.56% in Canadian dollar terms.
The World Bank estimates that a global influenza pandemic
similar to the one in 1918 would cost
the modern economy 3 trillion us dollars.
In their 2009 global financial stability report
the IMF estimated the cost of the 2007 to 2008
global financial crisis at 4 trillion us dollars
from write downs on bad assets alone.
I'm not saying that this time is indifferent
but I am saying that investors have a long track record
of being compensated by positive expected stock returns
in exchange for taking risk.
Narratives are powerful and often important
but they can affect the way that we interpret facts.
I think that it's important to step back
and look at the broader set of data
on what happens after market drops
before responding to a decline in stock prices,
regardless of the narrative you should be invested
in an asset allocation that you can stick with
in both good times and bad.
Getting out when things get bad
is one of the best ways to sabotage
your persistently positive expected stock returns.
If living through a stock market drop has been too painful,
It might be a good time to ask yourself
if you were taking too much risk to begin with.
I'm not an epidemiologist.
Most people are not epidemiologists.
And most epidemiologists are not economists.
figuring out how the economic impact of a global
health crisis will play out is a challenging task.
The market has responded by pricing in lots
of new known information and lots of big unknowns.
Uncertainty increases risk, driving down asset prices
and driving up expected returns.
When the market declines, it's not time to get out.
This is when equity investors earn the equity risk premium.
I am not saying that this won't be hard.
The market might keep dropping.
And after each subsequent drop the decision not to sell
after the previous drop might seem increasingly regrettable.
But remember, everything is obvious in hindsight.
On any given day, including after a market drop,
The best thing that we can do is stick
to the plans that we made during calmer times.
The economy might take a big hit
but this is why you had an emergency fund.
Stocks might continue to drop, but this is why
you invested in a risk appropriate portfolio.
In the moment when things are uncertain
it can be challenging to make good long-term decisions.
This is why you made a plan and now
is the most important time to stick to it.
Thanks for watching.
I'm Ben Felix of PWL Capital
and this is Common Sense Investing.
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with someone who you think could benefit
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(whirring music beats)