The 10-year anniversary in October of the S&P 500 historical high point before the so-called “Global Financial Crisis” is approaching. Over the following year and a half, US stock markets declined by more than 50 percent. Today US equity markets are surpassing old records almost daily, and fears from the dim past are coming back to haunt investors as a fateful October looms.
Over the next year financial media outlets will recount in tiresome detail various anniversaries of the Global Financial Crisis, such as the bank run on Northern Rock or the collapse of Lehman Brothers. Retrospectives will opine on how conditions today may be similar or different from back then. Politicians and officials will pontificate to media commentators, and assure the public that next time it will be different.
While it may be different next time, will that difference be positive or negative, we silently ask ourselves? Some investors, enriched from multiple years of generous stock market returns, are now beginning to worry whether their previous investing methods will continue going forward. For instance, I was recently emailed a “Real Wealth Report” titled, “Countdown to Armageddon.” But who knows when and how the next crisis will happen? I surely don’t. The good news is, you don’t need to know in order to have a successful financial experience.
Short-term, financial markets are always unpredictable. Further, we must be cautious drawing firm conclusions from the only sample of historical data in our possession. Still, important lessons for surviving and prospering during difficult times can be learned from available empirical research data.
So let’s understand that 2007 wasn’t a unique historical event of precipitously falling market prices. And it won’t be the last such event, either. Some investors still haven’t recovered from a 2007-2008 debacle, but others had advice that helped them prosper during a time when others failed. Anyone wanting confidence for planning their future lifestyle needs professional advice for an informed approach that works to preserve and grow wealth in both good times and bad.
Learning from History
In 2008, the stock market dropped by almost half its aggregate value. Fear gripped the nation, fed by nightly news reports and daily internet access. Investor panic some days was palpable. For a year, worried phone calls from concerned clients rarely stopped. As events unfolded daily, predictions of today’s prosperity would have been met with derision. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”[1] “Markets in Disarray as Lending Locks Up,”[2] and “For Stocks, Worst Single-Day Drop in Two Decades”[3] were common front page news. Reading the news, opening up quarterly statements, or going online to check account balances were stomach-churning experiences.
The eventual rebound and double-digit gains over the past decade have caused bad memories to fade, and a new group of investors with no memory of that past (or of history in general) have arrived. The new investor difference today is, rather than get information daily using desktop computers, these novice investors Google it instantly on their iPhones.
While current historically low market volatility is by no means worry-free investing, the feelings of panic and dread felt by investors and speculators alike during the global financial crisis were acute. Investors without a defined investment strategy or a practical investing philosophy reacted emotionally, often selling most or all stock or fund positions in the heat of the moment, promising themselves they’d “get back in” when it “looked safe.” Not a few are still in cash, still awaiting for that moment of clarity to occur. On the other hand, investors committed to a clear investment strategy were usually able to stay the course, and recovered completely They were further enriched from almost a decade-long rise in stock values.
The Global Financial Crisis was not the first occurrence of severe market volatility, as we have remarked. Exhibit 1 looks at six such times in just the past four decades. This exhibit illustrates the hypothetical performance of a multi-dimensional strategy similar to our standard methodology for a balanced growth allocation based on 1, 3 and 5 year periods. Each event is labeled with the month and year that key event occurred (such as the bankruptcy of Lehman Brothers) or that the US stock market reached a record peak. Anyone accumulating a retirement portfolio based on individually-developed multifactor investing strategies such as these should be reassured of the soundness of their planning.
Exhibit 1. The Market’s Response to Crisis Events
Although any portfolio strategy following a crisis event suffered immediate price declines in the succeeding months, in each case these models recovered and, in line with their allocation of equities versus fixed income, significantly grew as capital markets recovered. While average 1-year figures are modest, the 3-year cumulative average is 22.5% and the 5-year cumulative average is 61.3%. Engaging an informed multi-dimensional investment strategy that is appropriately aligned with goals and risk preferences should encourage disciplined investors to expect better outcomes with greater confidence, compared to investors simply speculating, timing markets, or using conventional tactics.
Conclusion
Capital markets historically have rewarded long term investors. Having an investment approach you can stick with better prepares you to accept crisis. So what insights does our study suggest? First, patience must be measured in years, not months, for successful investment management. Second, portfolio design, trading, diversification and rebalancing must be managed cost-effectively. Lastly, before any crisis event occurs, investors should have a strategic framework for planning and accumulating wealth already in place to turn those inevitable turbulent times to their advantage.
These are our foundational principles, as articles of faith, for an informed investment strategy: First, public capital markets reward long-term investors who accept market risk. Second, having an investment approach you can remain committed to through extraordinary times of boom and bust is essential for experiencing positive investing outcomes.
In the minds of one investor segment, there is always a potential crisis event looming that could mark the beginning of a financial disaster. We believe attempting to predict the future, or predicting how markets will react to future events, is an exercise in futility. Market reward is related to market risk. To obtain higher expected returns relative to risk-free investments like bank accounts, investors must embrace market uncertainty. A sensible investment strategy, developed with an acknowledged professional, can prepare you to better face uncertainty, better stick with your plan, and have your portfolio better capture potential higher multifactor returns that capital markets offer investors.
The importance of having an strategic investment framework specially customized for your unique family circumstances cannot be overemphasized. An experienced wealth management consultant can design and maintain the right asset allocation approach, using a professional process that can keep your planning on course. Yes, there will be inevitable periods of disappointment that challenge even the most informed client. An acknowledged professional can guide you and keep you focused on what matters for successfully managing wealth that leads to a great retirement lifestyle, and leaves a legacy for family, community, and causes you care most deeply about.
Appendix
Balanced Strategy 60/40: The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money. The balanced strategies are not recommendations for an actual allocation. International Value represented by Fama/French International Value Index for 1975–1993. Emerging Markets represented by MSCI Emerging Markets Index (gross dividends) for 1988–1993. Emerging Markets weighting allocated evenly between International Small Cap and International Value prior to January 1988 data inception. Emerging Markets Small Cap represented by Fama/French Emerging Markets Small Cap Index for 1989–1993. Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One‑Year prior to January 1990 data inception. Five-Year Global weighting allocated to Five-Year Government prior to January 1990 data inception. For illustrative purposes only. The Dimensional Indices used have been retrospectively calculated by Dimensional Fund Advisors LP and did not exist prior to their index inceptions dates. Accordingly, results shown during the periods prior to each Index’s index inception date do not represent actual returns of the Index. Other periods selected may have different results, including losses.
Index Descriptions
Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th‑largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market‑capitalization‑weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.
Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.
Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.
Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Source: Dimensional Fund Advisors LP.