It’s Not the Fall That Kills You

On a recent hike I found myself at the top of a high escarpment. I’ll admit to some discomfort while standing at the edge, peering over the side. As someone who’s never much enjoyed the thrill of heights, I found myself with a single all-consuming thought: “that’s a long way down.”

One could make the same comment about the market decline we witnessed earlier this year.

What’s interesting about the fear of heights is that it comes not from the height itself, but rather our fear of the fall.  And this fear is not confined strictly to high cliffs and skydiving. It is very much present in financial markets as well.

For example, we expect many investors endured some feelings of fear earlier this year as markets underwent a gut-wrenching drop to kick off 2016. Indeed, the first week of U.S. stock market trading saw a remarkable plunge of 6.2%, the worst start to a year ever experienced in the U.S.

But do these short-term market dislocations matter much in the long term?

We think a look back at history provides some interesting insights into this question. The chart below shows the S&P 500 Index’s annual returns (gray bars) and the largest intra-year stock market declines (blue dots) every year from 1980 to 2015.

Notice that the market is capable of delivering positive annual returns even when it suffers large intra-year drops. In fact, history shows that this ability of the market to recover after a big swoon is more the norm than the exception. Despite the fact that the market experienced an average intra-year drop of 14% every year over this period, the market still produced positive returns in 28 of 36 years.

This ability to recover from a fall is a wonderful characteristic of markets, because it means the fall does not always result in disaster. In other words, investors can avoid the fate articulated by the author Douglas Adams when he said “it’s not the fall that kills you; it’s the sudden stop at the end.” Often markets fall, grow wings and come right back up again, avoiding that unfortunate end at the bottom of the cliff. So far, that’s the story of 2016.

While the numbers in the chart tell a compelling story, the same concept – that markets go up and down, sometimes erratically – can be expressed by the allegory of “Mr. Market”. For those who may not have come across him before, Mr. Market was introduced by renowned value investor Benjamin Graham in 1949¹. He is a personification of the collective voice of the market, who shows up every day to buy or sell any financial asset. In the words of Graham, “sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.”²

To us, the wild ride of the market in early 2016 has been a good reminder of the ups-and-downs that are the hallmark of Mr. Market’s unpredictable behaviour. The benefit of trading with Mr. Market is that sometimes, when markets are volatile and investors are fearful, there are opportunities to identify securities with an intrinsic value that is different from the price quoted in the market. To act on these opportunities requires a steadfast focus on the long term, given that it is often the short-term crowd that drives these periodic bouts of fear and subsequent declines in the market.

Volatile markets are part and parcel of the world we live in. And let’s be clear, at times there are very good reasons to be fearful. However, as long-term investors, we know that alternating moments of fear and euphoria in the market simply can’t be avoided, nor can they be predicted. Nevertheless, we can take comfort in the fact that big drops are often followed by recovery, and sometimes those drops create wonderful opportunities to buy out-of-favour assets whose future return prospects are promising.

The key to taking advantage of this volatility is to have a long-term perspective and an investing approach that builds in a margin of safety. That combination can provide the confidence that is key to investing in a world of uncertainty.