Understanding market downturns and recovery cycles

Market volatility in context

Everyone saving for retirement is likely to encounter several downturns over the course of their lifetime. According to analysis by the chief economist of Vanguard, between 1980-2020 investors experienced eight “bear markets” (defined as a decline of 20% or more lasting at least two months). In that time, markets have seen 13 “corrections” (a decline of 10% or more). Over that same 40-year period, the value of global equities increased by a magnitude of 17 times.

Time horizon plays a big role in understanding the impact of these downturns. The table below (again borrowing data from Vanguard) shows the four most significant bear markets and corrections in the last 40 years, as well as the length of time markets took to reattain their pre-downturn levels.

Let’s look specifically at the 2008 financial crisis. In the depth of the downturn, stock markets had fallen roughly 50% from their pre-crisis peak, making for very challenging times for many investors. However, investors who “stuck it out” through this period of volatility were well rewarded – by 2012, markets had regained all losses and returned a total of 60% in the following five years.

The risks of timing the market

In periods of high volatility like what we have experienced with the pandemic, many people are tempted to “seek safety” and avoid further losses by pulling out of the market (for example, by selling investments), telling themselves that they will buy back in when things return to normal and the market starts to recover.

As personal finance columnist Rob Carrick put it in The Globe and Mail, “Getting out of the market is a lot easier than getting back in”. Strong psychological factors work against us. In Carrick’s words, “If you were stressed enough to bail on the markets, it’s unlikely you’ll have the fortitude to jump back in at the market nadir.”

Secondly, getting market timing wrong is costly. Extensive research has found that over the long run, the stock market’s outperformance over cash boils down to just a few critical months, which occur mainly during periods of recovery from drawdowns and periods of climbing to new peaks. Missing these critical months means missing out on all the risk premium to be earned from holding a more volatile asset such as stocks.

Analysis from JP Morgan has quantified the effect of market gains occurring in a relatively short window of time, finding that an investor who missed just the 10 best days in the stock market over a 20-year period would have seen their returns cut in half. Empirical data suggests that many investors suffer from the effects of bad market timing. Poorly timed withdrawals have been estimated to cost average mutual fund investors roughly 0.15% per month.

Stick with your plan

It is important to stay the course in periods of volatility. Attempting to time the market is hazardous. To help members avoid these risks, we have built specific features that help you effectively manage market volatility, including:

Regular, automatic monthly contributions
Saving money is the best advice regardless of the state of the economy. The ability to contribute to your plan directly from your paycheque and your personal bank account through regular, automatic monthly contributions reinforces the habits that lead to great financial outcomes.

Highly diversified target date funds better protect against risk
At Common Wealth, we automatically match and invest your savings in an age-appropriate target date fund from BlackRock®, the world’s largest asset manager. BlackRock® LifePath funds offer a mix of stocks, bonds, real estate, and infrastructure, with over 10,000 underlying funds across different types of investments and markets to better protect against risk.

Automatic portfolio rebalancing adjusts risk based on your age
With Common Wealth, your plan automatically adjusts to become more conservative as you near retirement. This means for individuals who do not plan to retire for many years, the long-term performance of higher risk assets, such as stocks, outweighs short-term downturns. For individuals who plan to retire in the near future and would normally be at higher risk during a market downturn, the BlackRock® target date funds help mitigate risks by automatically shifting your portfolio towards lower-risk investments as your retirement date approaches. The result: your investments grow during your working years and are protected as you get closer to needing your nest egg.

All data used here refers to the Dow Jones Industrial Average (DJIA), a price-weighted index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The DJIA is widely used to track stock market activity.