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Picking Your Battles

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Seeking Protection Against Bears Instead of Corrections

Recent glob­al equi­ty mar­ket sell-offs, like those seen in the first quar­ters of both 2016 and 2018, jus­ti­fi­ably gen­er­ate media atten­tion and investor con­cern. But they also present an oppor­tu­ni­ty to eval­u­ate risk.

While mar­ket draw­downs are inevitable and nec­es­sary for healthy mar­kets, investors don’t exact­ly jump for joy when one occurs. It’s impor­tant, how­ev­er, for investors to remem­ber the dif­fer­ences between the two types of mar­ket down­turns; cor­rec­tions and bear mar­kets. In an indus­try too often focused on short-term returns, cor­rec­tions can cause short-sight­ed reac­tions that neg­a­tive­ly impact long-term plans.

This post defines and com­pares the nature of cor­rec­tions and bear mar­kets, ana­lyzes their impacts on investors, and con­sid­ers which type of down­turn is more impor­tant to seek pro­tec­tion against.

 

From Complacency to Panic

Pro­longed bull mar­kets with peri­ods of low volatil­i­ty can cre­ate risk com­pla­cen­cy and even risk amne­sia. Any sub­se­quent mar­ket cor­rec­tion and/or spike in volatil­i­ty often shakes investors out of their state of com­pla­cen­cy and ignites fear of what they may have tem­porar­i­ly forgotten—markets can and will go down.

Because loss aver­sion is such a strong emo­tion­al dri­ver, it is typ­i­cal for many investors to tran­si­tion quick­ly into a state of pan­ic. Media cov­er­age of mar­ket tur­moil or dai­ly loss­es for major indices can com­pound investor anx­i­ety and dri­ve ner­vous calls to advi­sors.

 

Corrections versus Bear Markets

Invest­ing opens investors up to the pos­si­bil­i­ty of losses—but math­e­mat­i­cal­ly speak­ing, not all loss­es are equal. Under­stand­ing the dif­fer­ent kinds of loss­es between a cor­rec­tion and bear mar­ket may help investors bet­ter han­dle or pre­pare for them.

  • Cor­rec­tions come and go, with mar­ket loss­es and recov­er­ies occur­ring with­in the span of weeks or months. As such, cor­rec­tions are gen­er­al­ly speak­ing a blip on the invest­ment jour­ney.
  • Bear mar­kets cause more sig­nif­i­cant loss­es that require much more recov­ery time. Unfor­tu­nate­ly, bear mar­kets can be plan-alter­ing and life-chang­ing, both finan­cial­ly and emo­tion­al­ly, if port­fo­lios and investors are unpre­pared.

In the past 20 years, the S&P 500 Index has expe­ri­enced five cor­rec­tions (not includ­ing the cor­rec­tions occur­ring as part of bear mar­kets) and two bear mar­kets.

Cor­rec­tions are often defined as loss­es in mar­ket val­ue exceed­ing 10% but less than 20% and hap­pen from a mar­ket high. Cor­rec­tions have his­tor­i­cal­ly last­ed from between a few weeks to a few months from start of the down­turn to full recov­ery.

Table A Corrections 1998 - 2018 - Pick Your Battles - Swan Blog

Source: Yahoo Finance, S&P 500 Total Return Index

Bear mar­kets are defined as loss­es in mar­ket val­ue of 20% or more and have his­tor­i­cal­ly last­ed sev­er­al months to sev­er­al years. The loss­es expe­ri­enced in bear mar­kets are more intense and require longer recov­ery peri­ods on aver­age than cor­rec­tions, as shown below.

Table B Bear Markets 1998 - 2018 - Pick Your Battles - Swan Blog

Source: Yahoo Finance, S&P 500 Total Return Index

 

Speed

The speed of the draw­down refers to how fast, mea­sured in days, the mar­kets fall from peak to trough. Over the past twen­ty years, the speed of the fall for cor­rec­tions can be mea­sured in a mat­ter of days to a few months, while the bear mar­kets took much longer, gen­er­al­ly extend­ing over a year.

While faster draw­downs impact emo­tions and media response, what is more impor­tant to investor out­comes is the mag­ni­tude or inten­si­ty of the draw­down and the length of the recov­ery.

Speed of Drawdown 1998 - 2018 - Pick Your Battles - Swan Blog

Source: Yahoo Finance, S&P 500 Total Return Index

Intensity

The inten­si­ty of the draw­down mea­sures how much mar­ket val­ue was lost. As defined ear­li­er, cor­rec­tions are mar­ket loss­es of between -10% and -19%. Over the last twen­ty years, the most intense cor­rec­tion deliv­ered a 19% draw­down and the least intense cor­rec­tions cre­at­ed a mar­ket val­ue loss of about 12–13%. By com­par­i­son, the mag­ni­tude or inten­si­ty of loss­es dur­ing bear mar­kets are often more dif­fi­cult for investors to stom­ach. Although a bear mar­ket is defined as loss­es in val­ue of more than 20%, the two in the past 20 years were more than -47%, more than dou­ble the loss­es caused by cor­rec­tions. The inten­si­ty and effects of a bear mar­ket are unmatched, espe­cial­ly when we con­sid­er time of recov­ery.

 

Recovery

Recov­ery time refers to how long it takes for the mar­ket to recoup its loss­es and return to pre-fall lev­els. Math­e­mat­i­cal­ly speak­ing, the larg­er the loss, the larg­er the gain need­ed to recov­er. So if mar­ket cor­rec­tions cause small­er loss­es by def­i­n­i­tion, one could rea­son they would require less recov­ery time.

It is impor­tant to note here, that recov­ery time depends on the inten­si­ty of the draw­down and the nature of the mar­ket after the draw­down ends and recov­ery begins, so recov­ery times are not always in direct cor­re­la­tion to the draw­down inten­si­ty.

The -13% draw­down of the 2015–2016 cor­rec­tion took about two months to recov­er while the -19% cor­rec­tion in 1998 took only about three months. The -11% drop in 2000, though, took almost five months to recov­er.

Despite the dis­crep­an­cy between cor­rec­tions’ draw­downs and recov­ery times over the last 20 years, they all took less than half a year to recov­er. The recov­ery for the bear mar­kets, how­ev­er, required years of recov­ery time.

 

Duration

The dura­tion of a draw­down includes both the total length of time the mar­ket took to fall from a peak to the trough and the length of time to recov­er the loss­es back to the pre-draw­down lev­el.

The graph below shows the depth and dura­tion of loss­es of the cor­rec­tions and bear mar­kets.

Measuring Pain 1998 - 2018 - Pick Your Battles - Swan Blog

Source: Yahoo Finance, S&P 500 Total Return Index

The bear mar­ket dur­ing the Dot-com Bust of 2000–2002 may have cre­at­ed a small­er draw­down than the bear mar­ket dur­ing the Finan­cial Cri­sis of 2008-09, but its dura­tion was much longer. Tables A and B above show aver­age dura­tion of cor­rec­tions can be less than a year while bear mar­kets can go beyond four years.

If on aver­age it takes less than a year for investors to move on from a cor­rec­tion, are cor­rec­tions worth all the fuss?

In con­trast, a bear mar­ket gen­er­al­ly takes years before recov­ery is realized—and some­times longer for the investor to men­tal­ly and emo­tion­al­ly recov­er. That sort of recov­ery time can seri­ous­ly wreck a long-term invest­ment plan or delay goals like retire­ment start dates or col­lege edu­ca­tion fund­ing.

 

Corrections: Practice Runs for Risk Management

Cor­rec­tions may hap­pen more often, but on aver­age, they tend to be less intense and short­er in dura­tion. Gen­er­al­ly, they do not derail investors from their finan­cial goals.

Bear mar­kets, on the oth­er hand, are much more dis­rup­tive for peo­ple hop­ing to achieve their goals, result­ing in major loss­es that take years to recov­er from. For those near or in the retire­ment phase, these loss­es can be par­tic­u­lar­ly detri­men­tal.

Cor­rec­tions are often a wake-up call for investors to con­sid­er man­ag­ing risk. But if investors and their port­fo­lios are unable to with­stand a 10% cor­rec­tion, are they pre­pared for the pos­si­bil­i­ty of an actu­al bear mar­ket? With the recent pan­ic sur­round­ing the Feb­ru­ary 2018 cor­rec­tion, it seems many may not be ade­quate­ly pre­pared.

 

Don’t Panic—Prepare

The cur­rent mar­ket and volatil­i­ty regime we’re in now sug­gests more uncom­fort­able down­ward moves may be ahead, which may make it hard­er for investors to hold on to a “buy-and-hold” strat­e­gy.

It’s our phi­los­o­phy to hedge mar­ket risk direct­ly in order to lim­it loss­es dur­ing bear mar­kets and help investors remain invest­ed and on track with their invest­ment goals. We under­stand you can’t invest in risk assets and simul­ta­ne­ous­ly pro­tect against both small­er, short-term loss­es (cor­rec­tions) and larg­er, longer-term loss­es (bear mar­kets) and giv­en the dif­fer­ence in the nature and impacts of cor­rec­tions ver­sus bear mar­kets, we’ve cho­sen to seek pro­tec­tion from the lat­ter. We believe in man­ag­ing against poten­tial­ly life-alter­ing loss­es to port­fo­lios rather than seek­ing pro­tec­tion from what are often bumps on the invest­ment jour­ney.

 

About the Author

David Lovell - Director of Marketing - Swan Global InvestmentsDavid Lovell, Direc­tor of Mar­ket­ing, is respon­si­ble for Swan’s mar­ket­ing and engage­ment ini­tia­tives. This includes devel­op­ment and exe­cu­tion of mar­ket­ing pro­grams for Swan’s web­sites, con­tent, com­mu­ni­ca­tions, events, and media. David began his career in the finan­cial indus­try at Mass Mutu­al, where he held life, health and dis­abil­i­ties insur­ance licens­es, as well as, Series 6 and 63 licens­es. David cur­rent­ly holds a Series 65 license.

Important Notes and Disclosures

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards, and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and is net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com149-SGI-041218

By | 2018-04-15T09:56:53+00:00 April 12th, 2018|Blog|Comments Off on Picking Your Battles