David E. Bush, CPA, CFP, PFS Deja Vu, All Over Again

Member of the Firm

On July 19, 2007, the S&P 500 Index closed at 1,553. By August 15, it had fallen to 1,407, a drop of almost 10 percent. The media commented about how this was an unprecedented event. The following statement from Matthew Rothman of Lehman Brothers Holdings Inc. is a good example: “Wednesday is the type of day people will remember in quant-land for a very long time. Events that models only predicted would happen once in 10,000 years happened every day for three days.”

What went wrong? These events have occurred in the past. Consider the following:

The hedge fund Long-Term Capital Management (LTCM), founded in 1994, produced annualized returns of over 40 percent in its early years. Then, in 1998, it lost $5 billion. In 2000, the fund folded. LTCM failed because its models said the same thing that Rothman’s model had told him.

Historical Evidence

According to Roger Lowenstein’s book When Genius Failed, professor Eugene Fama said the following regarding the historical distribution of stock returns: “If the population of price changes is strictly normal, on the average for any stock…an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three to four years.”

Also consider the following:

From 1926–2006, 23 of the 81 years produced negative returns. In 10 years, the losses exceeded 10 percent. In five years, the losses exceeded 20 percent. In two of the years, the losses exceeded 30 percent. In one year, the loss exceeded 40 percent.
During the same period, out of 324 quarters, there were 27 in which losses exceeded 10 percent. There were also seven quarters when losses exceeded 20 percent. And there were two quarters when losses exceeded 30 percent.

Bottom Line: Stocks are risky and severe losses are fairly common. The only questions are when the risks will show up, how sharp the declines will be and when will they end. In other words, can you time the market?

Consider the findings of a study of market timing by 100 large pension funds, cited by Charles Ellis in his book Investment Policy: “While all the funds had engaged in at least some market timing, not one of the funds had improved its rate of return as a result.”

Why do market timers get such poor results? One reason is that they have to be right twice, once when they sell and once when they buy back in. We saw earlier that of the out of 324 quarters from 1926 through 2006 there were 27 in which losses exceeded 10 percent. Of those 27 quarters, 16 were followed by quarters when the S&P 500 Index rose at least 5 percent, seven when it rose at least 10 percent, four when it rose at least 20 percent, three when it rose at least 30 percent and two when it rose at least 80 percent. Following quarters when the market fell at least 10 percent, the next quarter it rose at least 5 percent almost 60 percent of the time. There were also three other quarters when the market rose, though less than 5 percent. Over 70 percent of the time after experiencing a quarter of a sharp decline, the market rose.

The Winner’s Game

Successful investors build bear markets into their plans. They begin by determining their ability, willingness and need to take risk. That helps them to determine an appropriate asset allocation and stick to it, keeping their heads while others are losing them in panic.

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm.