The Five Realities of the Stock Market

The stock market is often misunderstood especially during periods of high volatility.  What we believe should be reality is sometimes not.  Back in 2001, I wrote a special report called Peace of Mind in Uncertain Times after the beginning of the tech bust and also the fallout of 9-11.  In that report I shared my 5 realities of the stock markets which seems quite relevant for any period of market volatility.

Reality #1:  Markets will go down from time to time.

As obvious as this sounds, investors hope that markets never go down.  Yet market drops are a reality and therefore the stock market has investment risk.  This reality has been all to common over the past 10 years but there is a couple of reasons to remain optimistic about investing in the stock market.

  1. Markets go up more often than they go down
  2. Not only do markets rise more frequently, but they tend to increase in higher magnitude than the drops.

Consider some of the facts from the last 90 years,

  • Markets have gone up 73.9% of the time
  • Markets have gone down 26.1% of the time
  • The market gained more than 20% in 33% of the time
  • The market lost more than 20% in 4.5% of the time
  • The gains in positive years produce more than double the losses in the negative years

(This data is based on calendar year returns of the TSX from 1920 to 2010).

In addition (courtesy of Rob Carrick of the Globe and Mail),

  • In 34 of the 37 corrections of 10%+ since 1950, the stock market was up 12 months later by 26.8% on average.
  • Average decline for the 37 market plunges of 10%+ since 1950 is 19.7% or almost one every 20 months.

Reality #2: Markets typically rebound after down years.

There’s an old saying in investing: “What goes up must come down and what goes down must go up.”

You see, the real problem here is one of investor psychology.  When markets go up, we think they will keep going up and when markets go down, we think they will keep going down.  Psychologically, we can help but think in straight lines (linear extrapolation).  The reality is everything goes in cycles – markets, economies, interest rates, businesses, and even life.

When markets are down, investors tend to shy away from investing for fear of markets continuing to drop.  However, they cannot drop forever.

Research suggests that markets tend to rebound after negative years.  If we go back to the post war era, markets have only had back to back negative years 3 times in over 55 years of history (1974, 1970, and 1953).  The moral of the story is simple: The odds are in your favour that markets will rebound sooner than later (despite what your emotions tell you).

Reality #3:  Times change but nothing is really different.

The current stock market volatility has been fostered by what we call the ‘US Debt Crisis’.  The reasons for this set back may be different, but setbacks occur regularly for different reasons.

In 2008, It was the global financial crisis
In 2001 it was the bursting of the technology bubble
In 1997, it was the world currency crisis spurred from the Asian economies.
In 1994, it was the Emerging Market fiasco
In 1987, it was a result of financial panic and Black Monday
In 1973, it was the Oil Embargo
In 1962, it was the Cuban Missile Crisis
In 1950, it was the Korean War
In the 40’s it was the World War.

For as long as the stock market has been around, there are always bad things going on in the world that cause markets to jump around.  The good news is despite all of this bad news, markets continue to go up more often than they go down.

In the future, it may not be debt, war, technology or currency but rest assured markets will once again go through bear markets, corrections, and bad times.  After each of these bad times, markets turn around and exceed their previous highs.

In the end, the reasons markets change might be different but the realities are that markets change all the time.  There will always be volatility, on the downside, and the upside.  Remember when times seem to be tough, it will change and become prosperous once again.

Reality #4:  Market movements are random in the short term and predictable in the long term.

We have learned to this point that the stock market moves in cycles.  The obvious response is that if they move in cycles, we should be able to predict when these cycles occur ahead of time.

As much as we wish this to be true, the truth is nobody can predict the future of the stock market.  Why?  Because markets are random in the short term.  The shorter the term, the more random the movement.

Try this exercise: For the next 15 business days (three weeks) try to predict where the markets are going to go the following day. To keep it simple, all you have to do is predict whether it will go up or down (you need not worry about how much). The chance of you getting all 15 days right is less than 1 in 33000. To put this in perspective, you have a higher chance (1 in 9000) that the Earth will be struck by a huge meteor during your lifetime.

Hindsight is easy but no one was able to predict when any of the corrections and bear markets was going to occur.  It’s no different than being able to pinpoint when the markets were going to rebound and go back up.  After it happens it will seem very clear and obvious, but it will be impossible to see it ahead of time.

The only thing we know for sure is that markets will go back up and exceed their previous highs.  We just do not know when or how long it will take.  Long-term markets go up even despite short-term drops.

Reality #5:  Corrections and Bear Markets create excellent buying opportunities.

While psychology, emotions and sentiment work against you in trying times, it is important to try to ‘think’ instead of ‘feel’. In other words, is investing about logic or emotion? Solid investing has always been founded on logic.  Poor investment strategies have always resulted from emotion.

We’ve already learned that markets go up and down but they go up twice as often and twice as much.  Logically, when markets go down, the odds are in your favour to make money in the times ahead.

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace. For more information you can follow him on Twitter @JimYih or visit his other websites Group Benefits Online and Advisor Think Box.

14 Responses to The Five Realities of the Stock Market

  1. I think that number 3 is the one thing that we need to remember the most. There have been many other crises in the history of markets and each time, the markets have survived and then surpassed previous highs. Investing in good times and bad is the way to go.

    • I like your last point as it talks to consistency. When people invest inconsistently, I think that’s when they start to let their emotions make poor decisions.
      Thanks for stopping by again Cashflowmantra

    • Is that true?
      Short-term market timing is useless?

      Not sure if I agree.
      I think the argument has been simplified to the point where it is not to be questioned. I have been focusing on a few $10 companies, trading within a given band. I try to catch the lower side of the band by setting a buy order at $0.10 to $0.40 below the current price. If it hits (and it usually does), I sell whenever I can pocket $0.25 to $0.50 per share.

      $100/day on a $14k TFSA portfolio is not that bad, and as the portfolio grows, I’d like to increase the number of shares traded, but with a smaller spread.

      I am not bragging nor being argumentative; just questioning an assumed argument that, in my opinion, has still room for testing. On the other hand, after seeing so many blue chips getting clobbered over the last 30 months or so, I also question the other side of the buy-and-hold argument.

      Any thoughts?

  2. Point #4 is a great one. People look at volatility in the short term and avoid investing in the market for the long term. This really hurts returns when it comes to retirement (or other distant investing goals)

  3. Thank you for this list. It helps to be reminded of the history of stock market fluctuations. Puts things in perspective.

  4. Hi, Anil;
    What you’re calling short-term market timing really isn’t–it’s the one tried-and-true strategy for generating profit in the stock market; buy low, sell high. You’re just doing it over a short time frame, taking lots of small profit opportunities rather than few large ones–a perfectly valid strategy.

  5. one approach is a Warren Buffet approach where you seek out companies with a unique competitive advantage – net profit margins of say 15 per cent many companies may only have a figure of 1 or 2 percent. How can they have an advantage – Answer – well know brand name – company has low or no research costs – and these companies buy back shares with the profits to increase price per earnings eventually driving up stock price- hold for a long time and sleep or panic and sell on crashes if in a TFSA – and then with cash available -buy small chunks on dips – thus slowly and hopefully making money with winners- read Mary Buffet books – former daughter in law of Warren Buffet -ie Warren Buffet and the INTERPRETATION OF FINANCIAL STATEMENTS – buying on dips gives you better odds of profitting from long term winning stocks.
    Am I right or am I wrong. anyway recommend this book very highly for surviving market crashes

  6. I could not agree less with point #4. Certainly, it is not possible to predict the stock market in the short term; however, long term prediction based on historical models is effective. The US stock market is currently above its 2000 and 2007 bubble peaks; debt and speculation have been pushed to the limit with Fed (and other central banks) 0% interest and quantitative easing policies; and estimated returns on the stock market in the seven to ten year time frame can be estimated at about 2%. So it seems pretty obvious that a significant stock market correction is due within that seven to ten year time frame. The question is: Do you want to be on that roller coaster with a 2% risk premium, or invested in relatively safe and stable T-bills (at about 2%)?

    If you are close to retirement, I think the answer is obviously not. If you are 20 to 30 years from retirement, then a buy and hold equity stake balanced with real AAA bonds might make sense because you can take the hit and still make progress. If you are fully invested in the equity market, then “enjoy” the next ride–I am sure it will be “thrilling”.

  7. Every point you make has been proven again and again. If the average person (myself included) can get these concepts down and keep their emotions in check, they have a terrific chance to be successful investors.

    I only invest in mutual funds and have been very pleased since the last market downturn.

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