04 February 2021





THE MOST IMPORTANT CHART YOU WILL EVER SEE TO UNDERSTAND THE STOCK MARKET




By Raul Elizalde

This article also appeared on forbes.com


Stocks took off since last March on the back of high liquidity and promising signs that vaccines could bring the Covid-19 pandemic under control. Investors have been increasingly optimistic and some made their first significant forays into stocks in a while just as they reach an all-time high. Chances are that they will suffer losses soon after they enter the market. This is not a short-term forecast, but a fact about how the market works.


Standard and Poors, the creator of the S&P 500 index, priced the index all the way to January 3, 1928 (way before its initial launch in March 1957), so there are now more than 93 years of data to understand how stocks behave. In that time the index climbed an astronomical 21,600%. However, if you pick any day at random in this 93-year history, the chances that the index value will lie below a previous all-time high are overwhelmingly high at 94.6%. The probability that you pick an all-time high followed by another increase is a mere 5.4%. When you enter the stock market on any given day, those are the odds you’ll have, which means that buying around a peak is most likely to be followed by a decline.


This may or may not sound very remarkable, but surely this is more alarming: The most it climbed after a record before falling below a new high was just 6.6% (in 1929), but the most severe dip since 1928 was a staggering 86% below a previous peak (in 1932). And while the index has stayed underwater for as long as 6,248 days (9/1929 through 9/1954), the longest streak of successive all-time-high records was just 9 days (6/1929).


All that data fits in this chart:

source: Path Financial LLC, Standard and Poors
The blue line represents returns above a previous all-time record, while the reddish line represents returns below the preceding peak. This depicts much more accurately how the average market participant experiences the stock market than the vastly more common historical graph, even though both are drawn from the same data.

source: Path Financial LLC, Standard and Poors
If market participants experienced the market like the second chart they would be far more successful at investing. The reason they are not is that their experience of how it feels to lose money resembles the first chart, even though both contain the same 21,600% return that the market delivered over time. The point that the first chart drives home is that in order to achieve solid, long-term returns, investors must give their portfolios time and accept that, paradoxical as it may sound, suffering losses is an inevitable and essential part in achieving long-term gains. That’s why understanding volatility is so important, and reacting impulsively to it so dangerous.

source: Path Financial LLC, Standard and Poors
There are some caveats. First, while holding onto stocks for longer brings along higher chances of success, riding the market’s ups and downs can be difficult to do in practice.


It is well known that humans are more sensitive to pain than to pleasure, and they suffer the sting of losses much more intensely than they enjoy the thrill of gains. In practice, this causes many investors to liquidate their positions as soon as they experience a loss that crosses their pain threshold. What the first chart shows is that this threshold has a high chance of being reached when measured from an all-time high, as stocks are now. The fear of suffering even steeper losses before finding a bottom leads many to exit the market too soon.


Professional portfolio managers sometimes try to deal with this problem by reducing volatility, even if by doing so they give up some upside. They do this for the sake of delivering a performance path that is not only more tolerable for investors, but that also helps them avoid early and untimely liquidations. This, in fact, had been the original reason of being of hedge funds, where the “hedge” part has the precise meaning of hedging against losses. Not all hedge funds have stayed true to that original goal.


At times, a market participant sells early in a downturn hoping to skip some of the decline and re-enter at a more advantageous level, thus “ratcheting up” gains by a tactical entry/exit process designed to that effect. While most investors do this to some extent, some hedge funds are built specifically around techniques that systematically attempt it. The processes involved are difficult for non-professionals to implement, and success can be elusive as market dynamics shift around.


Another caveat is that a portfolio that is subject to scheduled withdrawals is at a particular danger of falling short of its goals. Letting declines proceed unimpeded when funds are taking out at a moment of loss is equivalent to buying high and selling low – a sequence best avoided. That is why retirement portfolios have a heavy focus on risk management when they are used to pay for living expenses.


These caveats do not cancel the fact that a big factor in successful investing is time and that intervening losses are unavoidable. Investors riding the increasing optimism of today’s market better be aware that they will have to accept them in order to reap the rewards they seek.


Questions? Talk to us.