Tom and all,
From some research department -
How Has The Stock Market Historically Reacted to Its Largest Quarterly Losses?
"Investors need to maintain a long-term perspective."
It would surprise fearful investors that the biggest quarterly stock market losses in recent history have been followed by some of the most spectacular returns.
Itis said so often and written so frequently that the statement has become an investment cliche. Still, it is a concept worth reinforcing regularly. Maintaining a long-term perspective generally means sticking to an investment plan geared toward achieving a future goal. The difference between a long- and short-term investment approach can be likened to a series of stepping stones. Imagine that a stepping stone is a calendar quarter's performance. A step forward means a quarterly gain, a step backward implies a loss.
For the long-term investor, the steps won't necessarily follow a straight path every quarter, but over time it is hoped that they will lead to an ultimate goal, such as a comfortable retirement, a college education for the kids, the purchase of a business or the fulfillment of a dream. For the short-term investor the steps need not lead anywhere in particular. The short-term investor only hopes that the stones lead forward in the near future.
So, what's so bad about having a short-term focus?
The primary engines that drive short-term investors tend to be fear and greed. The short-term investor is frightened about the possibility of a plunge in stock prices and is prepared to take dramatic steps to avoid one. Greed is manifested in the desire to make a quick profit by buying stocks before they zoom in price.
Yet, it would surprise many fearful investors that the biggest stock market losses in recent history have been followed by some of the greatest returns. The table on page 4 shows the 10 biggest losses recorded by the stock market in a calendar quarter since 1940. These 10 losses averaged 16.2% and were as high as 25.2%. The remainder of the table shows that performance was typically exceptional averaging 23.2% - in the 12 months after a disastrous quarter. Annualized returns continued to remain above average for 10 years after the quarterly losses. Over the last 58 years, the average annual return of stocks was 12.7%, much less than the 1-, 5- and 10-year average returns shown in the table.
A short-term perspective can also lead investors to adopt investment strategies that they ordinarily would avoid, while damaging investment returns in the process. Recent research, for example, has shown that excessive assessments of performance lead people to grow more conservative with their investments.
At Tilburg University in the Netherlands, researchers recently published the results of a study in which they examined how the frequency of performance reviews impacted investment decisions. Subjects in the study were given money to bet on a series of 9 lotteries. Each of the 9 drawings offered the same odds:
A 67% chance of losing and a 33% of winning
2 1/2 times the amount of money bet.
With a short-term focus X one drawing, for instance X the bet might be unattractive to many people since the odds of failure were twice as high as the odds of success. However, when offered to make the bet 9 successive times, the attractiveness of participation increased because of the high payoff.
The researchers divided the participants into 2 groups. The key difference between the 2 groups was the amount of information supplied to each. The first group received more information about their performance and was given more flexibility in their betting decisions. This group was told to decide how much to bet on each of the 9 drawings before it was held. Most important, they were told the results of each round before placing their bets on the next drawing.
10 Worst Quarters Since 1940
(S&P 500 Index) Subsequent Returns:
Quarterly
Loss 1-Year
Return 5-Year
Average 10-Year
Average
1974 3rd Qtr. -25.2% 38.1% 16.8% 15.6%
1987 4th Qtr. -22.6% 16.8% 15.9% 18.1%
1962 2nd Qtr. -20.6% 31.2% 14.3% 10.5%
1946 3rd Qtr. -18.0% 6.5% 16.6% 18.4%
1970 2nd Qtr. -18.0% 41.9% 9.3% 9.1%
1940 2nd Qtr. -16.9% 5.7% 15.1% 12.3%
1990 3rd Qtr. -13.8% 31.3% 17.3% N/A
1941 4th Qtr. -12.9% 20.3% 17.9% 17.3%
1975 3rd Qtr. -11.0% 30.5% 13.8% 13.5%
1981 3rd Qtr. -10.2% 10.0% 20.2% 17.5%
Average -16.9% 23.2% 15.7% 14.7%
Source: Consulting Group
The second group was required to make 3 bets at a time. Unlike the first group, the second group wasn't told the results of each drawing. Rather, participants were simply informed the total value of their winnings and losses on the three previous drawings. Then, they were instructed to make their bets on the next three lotteries. Thus, participants in the second group had less freedom because they couldn't change their decision after each round.
In setting up the experiment, the researchers attempted to create two classes of subjects: the first had a short-term focus, the second had a longer-term focus. In analyzing the bets made by both groups, researchers discovered that the second group was more comfortable with taking risks on attractive opportunities. The researchers concluded that the more frequently investors analyzed their performance, the more reluctant they were to take chances.
"Our results suggest that providing investors with less frequent information feedback about how a particular risky (investment) is doing might make the (investment) appear more attractive by decreasing the likelihood that a loss will be experienced. Similarly, if investors are given less freedom of adjustment ("tying their hands"), this may induce them to evaluate financial outcomes in a more aggregated way, and help them to resist the temptation to drop out after the occasional setback," the researchers wrote in the Quarterly Journal of Economics.
The Perils of Market Timing
For those investors who are motivated more by greed than fear, a short-term focus offers the allure of incredible rewards. Investors are often tempted to "time the market" by buying heavily when they believe the stock market is about to rise. These investors can also profit by heavy selling when they believe that prices are about to fall. Yet, market timing strategies often fail.
Research has shown that the more investors attempt to time the market, the worse their performance. Boston-based consulting firm DALBAR conducted a study that looked at the performance of mutual fund investor behavior from January 1984 through December 1995. DALBAR found that the primary factor impacting investment performance was poor market timing by investors. Dalbar concluded that if investors practiced a simple "buy-and-forget-it" strategy over the 12-year period, they would have increased their returns more than threefold. Interestingly, DALBAR also found that market timing was less prevalent among investors who utilized Financial Consultants and more common among do-it-yourself investors.
Further evidence of the failure of short-term strategies came in a study conducted at the University of California. The study looked at the trading records of 10,000 accounts at a major discount brokerage firm from 1987-1993. Heavy trading by investors was counter-productive to performance. The study concluded that the stocks sold by investors actually outperformed their buys. One year after a trade, the average return of the stock bought by investors underperformed the stocks previously sold by 3.2%. In essence, investors would have been better had they done nothing, holding their stocks rather than replacing them.
"Trading volume in equity markets is excessive for a particular group of investors: those with discount brokerage accounts," the study concluded. "These investors trade excessively in the sense that their returns are, on average, reduced through trading.
Conclusion
Experience reveals that investors who pursue a short-term focus are often disappointed with their performance. Market timing is generally a no-win approach. Though there are some who choose to focus on performance jockeying, it has been clearly demonstrated that attempting to select investments at the most optimal time is usually a futile exercise in guesswork. The history of the stock market rebounds following large quarterly losses showed them to be excellent buying opportunities. Investors who have taken advantage of such periods recorded above-average returns.
The Consulting Group believes that the best approach for investors is a well-conceived plan that addresses the investor's particular risk and return requirements and focuses on their financial objectives over a long-term time horizon. Sticking to this plan in volatile markets and avoiding impulse investment decisions are perhaps the most challenging tasks facing the individual investor. Moreover, experience reflects that those investors with the discipline and perseverance to stick to a buy-and-hold strategy will ultimately be rewarded.
Brian H.
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