The Investment Scientist

Posts Tagged ‘bear market

“Ignorance is bliss” – American proverb

In 2002, Daniel Kahneman, an Israeli-American, won the Nobel Prize in Economics for his ground-breaking work in behavioral finance. During last prolonged bear market, the Israeli Pension Authority came to him with an all too common problem. Pensioners kept changing their investment allocations according to prevailing market conditions. These frequent changes not only were unhelpful for the long term, but also added costs to pension management. Kahneman gave them one simple solution: send the pensioners statements quarterly instead of monthly.

How can it help to know less about your investment performance?

I studied all seven bear markets since 1970 and calculated their peak-to-trough drawdowns (a reduction in account equity) from the perspective of four different types of investors:

  • A: Investors who check their accounts intra-daily
  • B: Investors who check their accounts monthly
  • C: Investors who check their accounts quarterly
  • D: Investors who check their accounts annually

Here are the results:

    S&P 500 Peak to trough drawdown
    Peak date Peak Trough date Trough A B C D
    3/24/2000 1552.87 10/9/2002 768.63 -51% -46% -46% -40%
    7/17/1998 1190.58 10/8/1998 923.32 -22% -10% -10% 0%
    7/16/1990 369.78 10/17/1990 294.54 -20% -15% -15% -7%
    8/25/1987 337.89 12/4/1987 221.24 -35% -30% -23% 0%
    11/28/1980 141.96 8/12/1982 102.2 -28% -24% -19% -10%
    9/21/1976 108.72 3/6/1978 86.45 -20% -17% -15% -12%
    1/5/1973 121.74 10/3/1974 60.96 -50% -46% -46% -42%

Two observations emerge from this study:

  1. Regardless of the cyclic nature of bull and bear markets, the S&P 500 index keeps marching upward. (You don’t want to stop that march!)
  2. The more frequently you check your accounts, the more painfully you feel (and probably will react to) a bear market.

Take the bear market in 1987 for example; the intra-day peak-to-trough drawdown was 35%. For type C investors who checked their accounts quarterly, the drawdown was only 23%. Type D investors who checked their accounts annually would not feel the pain at all since the bear market began and ended within the year. Who would be more likely to stay the course? Go figure!

The author is president of MZ Capital, a RIA serving DC/MD/VA.  Get his monthly newsletter in your mailbox or get to the directory of his past articles.

July 2008 marks the start of a bear market after all major market indices have fallen more than 20% from their most recently peaks. This article is part two of my three-part research on bear markets. In part one, I researched how long a typical bear market lasts?. In this installment I ask this question:

Which style fared the best in a one-year time frame after stocks have entered a bear market?

There are four primary styles of stock investing: Small Cap Value (SV), Small Cap Growth (SG), Large Cap Value (LV), and Large Cap Growth (LG). Typically, before stocks enter into a bear market, Small Cap stocks, regardless of value or growth, get hit the hardest.

Using data provided by Fama/French benchmark style portfolios, I calculated one-year returns of the four investment styles from the month stocks entered a bear market. The results are tabulated below.

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It’s official. On July 9, US stocks slid more than 20% from their October high, sending the S&P 500 into bear market territory. Even earlier this month the NASDQ and Dow Jones turned bearish following the Russell 2000, an index of small caps, which lead the decline.

How long will this bear market last?

Well, I don’t have a crystal ball, but I do have a rear view mirror.

Since 1960, there have been ten bear markets (see Table). The worst bear market took one-and-a-half years to reach bottom. Four reached bottom within a month. The remaining five hit bottom between one and ten months. On average, it took 4 months to reach bottom.

Date of entering bear market Months to bear bottom 1 year return from entry 3 year return from entry
2/26/2001 19 months -11% -8%
10/8/1998 < 1 months 38% 12%
10/17/1990 < 1 months 33% 59%
10/19/1987 2 months 3% 13%
3/1/1982 5 months 34% 63%
3/6/1978 < 1 months 13% 49%
12/10/1973 10 months -32% 9%
1/26/1970 4 months 10% 35%
10/3/1966 < 1 months 28% 24%
5/28/1962 1 month 20% 51%
Average 4 months 14% 31%

Data source: Moneycentral.com

Now that we are in a bear market, shall we move to cash?

I don’t recommend it. Here’s why. From the day the S&P 500 entered a bear market, on average it returned 14% in one year and 31% in three years.

Let’s look at the distribution of returns. This is important. Among the ten one-year returns, two were negative, yet three were over 30%. As for the three-year returns, only one was negative but three were over 50%!

I don’t know about you, but I like those odds.


Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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