Sunday, May 16, 2010

How Unusual Was 2008 and Should I Be Timid of Recent Volatility?

Through the sparkle-clean viewing glass of hindsight vision it does appear that 2008 was unusual yet not unprecedented. And, it appears that there is little reason to be timid over the long-term. Let us work through this summary in an attempt to provide substance for these answers.

Fama and French explains that the only year of the 1927-2008 period that produces a market return below -38.31% is 1931 (-44.36%). Three additional years have returns close to or below -30%: 1930 (-28.83%), 1937 (-34.61%) and 1974 (-27.95%). If one considers successive years of negative market returns, the cumulative return for the three-year period 1929-1931 is -66.35%, the return for 1973-1974 is -41.47%, and the return for 2000-2002 is -37.54%. On the plus side, the annual market return is greater than 30% for 15 individual calendar years of 1927-2008. In short, extreme stock returns are common. Fortunately, extreme positives outnumber extreme negatives.

Figure 1: Annual Market Returns 1927 - 2008

It seems apparent that, although difficult to stomach, extreme fluctuations happen and just as often to the plus side. Now let us work through one more point about investing for the long term that should help you rid yourself of this timid feeling so that sleep is more amenable the next time the market nose dives.

Treasury Bills are known for being relatively risk free. If we had moved from the riskier S&P index to the treasury bills in the boxed chart bellow, we would have missed out on the returns experienced in the other times of the chart. That being said, it is important that your portfolio is properly allocated and your risk appropriately assessed for you so that you can meet your goals.

To summarize, markets do fall and the necessity for good emotional management and proper risk assessment is critical for an investor. With the proper portfolio in place for the individual investor long term goals may be met so that it matters little if the market is bullish or bearish.

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