Every fall I am reminded of the wet seasons I experienced growing up in Haiti. The defining characteristics of that time of year were the harsh rains and driving winds from tropical storms forming out at sea. The frequency and intensity of these storms varied year by year; but my family and others like ours across the island always knew that someday another storm would make landfall, and we had no choice but to prepare ourselves for that eventuality.

As a Canadian, I have traded hurricanes and rising seas for apple picking and falling leaves; yet I have not forgotten the lessons learned living in a land where the possibility of a catastrophic storm is only one wet season away. In fact, I see many similarities in how we at TMA try to prepare clients for the possibility of investment storms.

The calm before the storm

While meteorologists know that hurricanes are restricted to one season a year, they still can’t predict the timing or severity of the storms. That is why my family would always ensure that we had everything we needed to last us through the worst of what Mother Nature had to offer. We set aside supplies, water, and clothing for emergency use. We had a generator if our house lost power, and an evacuation plan in case we had to seek shelter somewhere else. Every summer we would practice our safety drill to ensure that we knew what to do when a storm came. By following the plans and preparations we made in calmer weather, we were able to steer ourselves through the worst storms.

We can apply this forward thinking and prepare our clients for portfolio storms too. The most severe storms tend to happen every 4 to 8 years. Long-term data shows that 5% equity market corrections “typically” happen a few times a year. Every 1-2 years a 10-15% correction will probably occur and 20% declines tend to happen every 4 to 8 years. This fall we experienced a 10% correction.

In the past we used to show our clients bull and bear market slides (download here) to paint a more vivid picture of how markets work. Earlier this year we developed an interesting new investment drill for our clients. We were inspired by Rob McClelland’s “lifeboat drill”. Rob is a co-member of Final Frontiers Group, our best practice advisory peer group, and he shared his drill with us at last year’s FFG conference.

This investment drill empowers our clients to learn more about how model portfolio allocations would have done during past investment storms. Most importantly, it can help clients become emotionally prepared for the eventual storms that will come along.

Having these discussions in no way suggests that we are forecasting a storm around the corner. This is simply a preparation drill. Its greatest value is derived by our clients being prepared and not making emotional mistakes during market storms. It is better to prepare for the worst when conditions are at their best than it is to mistakenly assume that the good times will last forever. Our portfolios have experienced strong returns over the last few years; let us use this time to prepare ourselves for the future storms we’ll eventually have to face.

The investment drill

The investment drill allows us to insert a client’s portfolio into a model allocation in order to review how it might have done during different time periods. In this drill, we can see how the portfolio and various asset classes would have performed in the last six major bear markets going back to 1973. The investment drill tracks a variety of things;

  1. The percentage drop in the model portfolio
  2. The percentage drop in the various asset classes making up the portfolio
  3. The # of months it took from the initial portfolio value to the lowest point in the bear market
  4. The # of months it took from the lowest point in the bear market to get back to the initial portfolio value
  5. The total # of months to get through the full bear market cycle
  6. The portfolio’s value at the lowest point of the bear market (including the absolute dollar drop from the initial high point)
  7. The portfolio’s value 5 years from the start point
  8. The portfolio’s value 10 years from the start point

Below is an example of an initial portfolio value (IPV) of $1,000,000 invested 65% in stocks and 35% in bonds.

Performance of each asset class and the hypothetical portfolio during last six major bear markets*

 

Table 1

 

 

 

 

 

 

 

Portfolio value at the market bottom during each market correction and the loss incurred during the period

 

Table 2

 

 

 

Portfolio value 5 years, and 10 years from the initial portfolio value**

Table 3

 

 

 

Investment drill on a portfolio of 0% stocks / 100% bonds

Investment drill on a portfolio of 30% stocks / 70% bonds

Investment drill on a portfolio of 50% stocks / 50% bonds

Investment drill on a portfolio of 65% stocks / 35% bonds

Investment drill on a portfolio of 75% stocks / 25% bonds

Investment drill on a portfolio of 100% stocks / 0% bonds

 

Based on the above exercise, we are able to make the following observations:

  • Markets will experience corrections, and may even become bear markets from time to time.
  • On average, these bear markets have occurred every 4 to 8 years, but cannot be identified in advance.
  • Generally and over the long-term, markets have always recovered after a downturn.
  • When the down market does occur, investors are best off staying invested to avoid any panic selling and missing out on the subsequent recovery.
  • Investors are best off investing new cash during the down phases to increase their expected return.
  • As illustrated by the gains generated during the subsequent time periods, self-control and patience will eventually reward investors. Investors will achieve their long-term goals by having a financial plan and following it in a disciplined manner during good and bad times.

Clear skies & market storms: This too shall pass

Many unpredictable factors can have an impact on your portfolios. However, through proper asset allocation, rebalancing and diversification, we are better equipped to see ourselves through any storms. After living through a few hurricanes in my childhood, I came to realize that these periods of strong winds and heavy rain were simply another part of life. With proper preparations in place, I would be ready to face what was to come. Likewise, by preparing ourselves and our understanding of how markets work, we too can better endure the market’s storms when they come knowing full well that clear skies will return. Remember, every cloud has a silver lining.

 

* Bonds are represented by the Canadian One-Month T-Bills and the FTSE TMX Canada Long-Term Bond Indexes. Canadian stocks are represented by the S&P/TSX Composite Index; US stocks are represented by the S&P 500 Index; international stocks are represented by the MSCI EAFE Index (net dividends). This is for illustrative purposes only. It is not intended to project future rates of return.

 

** These numbers are based on nominal returns.

*** Regarding the Housing & credit crisis, the portfolio value is based on a period from the initial portfolio value to the 30th of April 2015 (7 years and 11 months).