How Can You Prepare for the Next 2008?
In early October 2007, the S&P 500 Index hit its highest point, then lost more than half its value over the next year and a half during the global financial crisis.
In the coming weeks and months, we’ll see anniversaries of other major crisis-related events (for example, Lehman Brothers collapsed ten years ago next week), and we’ll likely see a stream of retrospectives detailing what happened and offering opinions on how today’s financial climate may be similar or different from the period leading up to the crisis.
Because financial markets are habitually unpredictable in the short run, it’s challenging to draw useful conclusions based on these observations. However, there are important lessons investors would be well-served to remember: Capital markets generally reward long-term investors, and having a resolute investing approach may better prepare you for the next crisis and its aftermath.
But What About Really Bad Market Meltdowns?
In 2008, the stock market value dropped by nearly 50 percent. A decade removed from the crisis, it may be easier to take it in stride. And undoubtedly, the years of double-digit gains that followed have also helped our perspective.
But as the events of the crisis were unfolding ten years ago, this future was unforeseeable. Headlines read “Worst Crisis Since ’30s, With No End Yet in Sight,” “Markets in Disarray as Lending Locks Up,” and “For Stocks, Worst Single-Day Drop in Two Decades.” Daily rituals like checking the news, reviewing quarterly statements, or viewing account balances became nauseating encounters.
While today’s investor is by no means worry-free, the panic felt by many during the financial crisis was distinctly acute. Many investors reacted emotionally in the midst of the crisis, and decided to sell out their stocks. Conversely, many were able to stand by their investing approach, thereby holding them while recovering from the crisis and benefiting from the subsequent rebound.
It’s important to remember that this crisis, and the ensuing recovery, was not the first time historically that we’ve experienced substantial volatility.
Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September 2008, which took place in the middle of the financial crisis.
The Market’s Response to Crisis
Performance of a Balanced Strategy: 60% Stocks, 40% Bonds (Cumulative Total Return)
|1 Yr||3 Yr||5 Yr|
In US dollars. Represents cumulative total returns of a balanced strategy invested on the first day of the following calendar month of the event noted. Balanced Strategy: 7.5% S&P 500 Index,7.5% Fama/French US Large Value Index, 15% Fama/French International Value Index, 7.5% CRSP 6-10, 7.5% Fama/French US Small Cap Value Index, 15% Dimensional International Small Cap Index, 40% BofA Merrill Lynch 1-Year US Treasury Note Index. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2017 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. For illustrative purposes only. Dimensional indices use CRSP and Compustat data. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Not to be construed as investment advice. Rebalanced monthly. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance.
Although globally diversified, balanced investments would have suffered losses following these events, financial markets did recover, as demonstrated by the three- and five-year cumulative returns shown in the exhibit.
With a long-term outlook, appropriate diversification, and an asset allocation aligned with your risk tolerance and goals, you can stay disciplined amid financial discomfort. Financial advisors can play a pivotal role in working through these issues and counseling investors when things look grim.
So What’s the Takeaway?
For some investors, there is always a “crisis of the day” or potential looming event that could mean the beginning of the next drop in markets. It’s difficult to predict future events or how the market will react to said events, but it’s important to understand that market volatility is a part of investing.
To enjoy higher potential returns, investors must be willing to accept heightened unpredictability. An essential part of long-term investing is to stay with your investment philosophy, even when things are tough.
With a prudent, transparent investment approach, you can be better prepared to face uncertainty, and improve your ability to stick with your plan – ultimately capturing the long-term returns of capital markets.
To learn more about applying a sound retirement philosophy to your investment portfolio, check out our eBook, 12 Principles of Intelligent Investors.