Archive for the ‘Asset Classes & Allocation’ Category
Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.
- Small cap value: $3,750,000
- Small cap growth: $81,200
- Large cap value: $854,000
- Large cap growth: $130,000
- CD: $13,800
Isn’t it obvious which is the best long-term investment?
Why small cap value is the best long-term investment
So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)
Table: How would $1 investment become?
| 10 year periods | Small Cap Growth | Small Cap Value | Large Cap Growth | Large Cap Value | CD |
| 1958-1967 | $5.64 | $8.02 | $3.22 | $5.39 | $1.36 |
| 1968-1977 | $0.97 | $2.66 | $1.2 | $2.64 | $1.75 |
| 1978-1987 | $3.38 | $7.84 | $3.52 | $4.96 | $2.41 |
| 1988-1997 | $2.87 | $6.47 | $5.38 | $5.13 | $1.7 |
| 1998-2007 | $1.53 | $3.47 | $1.77 | $2.36 | $1.42 |
| Annual volatility | 28.23% | 24.05% | 17.67% | 18.54% | 1.7% |
Safety paradox
Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.
Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?
Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.
“Volatility does not measure risk.” -Warren Buffet
Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.
Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?
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What you need to know now the recession is here
Do you ever get that feeling that you’d rather just stay in bed? This morning was one of those mornings. We woke up to the painful news of stock market collapses across Asia and Europe. And then, more surprising, a sudden action by the Fed cutting the interest rate by three-quarters of a percentage point (75 basis points). We never know for sure whether we’re in a recession until National Bureau of Economic Research (NBER) makes it official. That could take up to six months. But the only conclusion I can draw from the immediacy of reaction from the Fed is that if we are not in a recession right now, it’s about to happen.
So what can we expect the stock market to do during a recession-and after it? I may not have a crystal ball to see the future, but I have made an in-depth study of all nine recessions since 1950. Even if history won’t repeat itself, looking at the past half-century should give us some perspective.
Things look gloomy now, but the future is not
How long does the average recession last?
Since 1950, a typical recession lasted for ten months. The shortest one lasted for six months and the longest one lasted for 16 months. (See column 2, Table 1 below.)
What have been typical returns during past nine recessions?
Five of the nine recessions saw the S&P 500 index increased during the downturn (See column 3, Table 1 below). The average index return during recessions was 3.14%.
One year into the start of a recession, the S&P 500 index, on average, increased an anemic 2.95%. (See column4, Table 1.) Yet there are only three instances during this period when the index dropped, and the largest of these was by a painful 27%. However, the remaining six first-year periods saw the index increase. The best of these was by 25%.
By the third year of the start of a recession, the S&P 500 index on average increased 28%, which is slightly below the normal rate of return for the index. There was only one instance when the index was below the start of the recession. (See column 5, Table 1.)
Ten years into the start of a recession, the S&P 500 index on average increased 139.6%. There were no instances of the index being below the start of such a long recession. It’s worth noting 139.6% for ten years is still below the normal rate of return for the S&P 500 index. (See column 6, Table1.)
Table 1: S&P 500 returns during and after recessions
| Recessions | # of months | During R | 1 year | 3 year | 10 year |
| Jul 1953 – May 1954 | 10 | 17.94% | 25% | 100% | 179% |
| Aug 1957 – Apr1958 | 8 | -3.94% | 6% | 26% | 107% |
| Apri1960 – Feb 1961 | 10 | 16.68% | 20% | 28% | 50% |
| Dec 1969 – Nov 1970 | 12 | -5.28% | 0% | 28% | 17% |
| Nov 1973 – Mar 1975 | 16 | -13.13% | -27% | 6% | 73% |
| Jan 1980 – Jul 1980 | 6 | 6.58% | 13% | 27% | 188% |
| Jul 1981 – Nov 1982 | 16 | 5.81% | -18% | 15% | 196% |
| Jul 1990 – Mar 1991 | 8 | 5.35% | 9% | 26% | 302% |
| Mar 2001 – Nov 2001 | 8 | -1.80% | -1% | -3% | |
| Average | 10 | 3.14% | 2.95% | 28.20% | 139.16% |
| Current recession started Dec 2007 | 18 | -34.8% | -39.2% | -9.9% | ? |
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Small cap value stocks will do better, if history repeats itself
I’ve used the Small-Cap Value Index constructed by Fama and French to study the effect of recession on small cap value stocks for the last nine recessions since 1950.
On average, the Small-Cap Value Index returned 11.39% during a recession. During those recssion periods, the returns of the Small-Cap Value Index ranged from barely dropping (-2.17% in the ’69 recession) to strongly rallying (38% in the ’81 recession). (See column 2, Table 2 below.)
One year into the start of a recession, the index on average returned 13.21% with only one instance of index decrease. (See column 3, Table 2.)
Three years into the start of a recession, the index on average returned 76.21%with 31% being the worst return. (See column 4, Table 2.)
Ten years into the start of a recession, the index on average returned 506.26% with 312% being the worst return and 1183% being the best. (See column 5, Table 2.)
The reason I recommend my long-term approach and staying with small cap value stocks is because of these results.
Table 2: Small cap value returns during and after recessions
| Recessions | During R | 1 year | 3 year | 10 year | |
| Jul 1953 – May 1954 | 10.11% | 21% | 100% | 362% | |
| Aug 1957 – Apr 1958 | -0.56% | 18% | 63% | 517% | |
| Apr 1960 – Feb1961 | 21.72% | 32% | 46% | 343% | |
| Dec1969 – Nov 1970 | -2.17% | 7% | 31% | 312% | |
| Nov 1973 – Mar 1975 | 17.81% | -13% | 86% | 1183% | |
| Jan 1980 – Jul 1980 | 3.11% | 15% | 96% | 499% | |
| Jul 1981 – Nov1982 | 38.29% | 0% | 95% | 387% | |
| Jul 1990 – Mar 1991 | 5.52% | 9% | 83% | 448% | |
| Mar 2001 – Nov 2001 | 8.68% | 31% | 86% | ||
| Average | 11.39% | 13.21% | 76.21% | 506.26% | |
How shall we learn from history?
We can take the short view. In the last six months, the S&P 500 has dropped more than 15%. The Small-Cap Value Index has dropped more than 25%. Should we conclude that at this rate, all investment in stocks will be lost in two to three years?
Should you panic now?
The answer is no. But that’s precisely what many investors are doing now by taking money out of the market or rotating them to stocks they perceive to be safer. There is a better way to learn from history.
Take the long view
If you want to sleep well while building your wealth for the long term, you must take the long view of history. Then you’ll be more like Warren Buffet and John Bogle who see the current market madness as normal and transitory. William Shakespeare could well have been talking about the emotional turmoil of the market when he wrote,
It’s like a tale told by an idiot, full of sound and fury, but signifying nothing.
Sleep well, take the long view.
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