The Importance of History

Being diversified and having an appropriate asset allocation is boring. That's what many people think, especially after the stock market has been on a tear for a while. A year like we've had so far helps accentuate this sentiment. When you're diversified, you don't have a large amount of your portfolio invested in the so-called FANG stocks (Facebook, Amazon, Netflix, and Google) that have done so well this year. You might have a small amount invested in them, so your portfolio does benefit, but you're not seeing the outsized returns that can come from investing heavily in a few stocks that happen to be doing well at the time. But you're not in danger of being bitten either. That's the tradeoff and it can be a tough pill to swallow sometimes.

It is important to remind ourselves of this tradeoff and recalling the lessons of history helps in this regard. Last Friday, September 15th, marked an important day in the history of the markets as the day in 2008 when Lehman Brothers failed. The 158-year-old investment bank was doing extremely well but, in hindsight, had massively overleveraged itself in the subprime mortgage market. As that market collapsed, Lehman found itself without a chair when the music stopped. Going into the weekend of the 12th the future of the bank was truly uncertain. Many market commentators and investors believed that someone somewhere, another company, or even the government, would swoop in to save the firm. But by late Sunday night everyone was shocked to learn that Lehman was doomed to bankruptcy. That Monday the stock market was down a ton and experienced massive volatility during the following days. Then, as we're all aware, an already precarious market and economic environment turned further south and the Great Recession ensued.

Why is the history of Lehman Brothers important to remember? Wouldn't we rather forget nasty market conditions and instead recall the market's recent upsurge? Of course! It's human nature to want to accentuate the positive, but remember that very little about investing is intuitive. It's hard to take the long view as parts of the market, or even individual stocks, race past you as they perform well for a time. And it can be harder still during times of market disruption, as with Lehman Brothers. So, we must remind ourselves that we're in this for the long run and that there will always be someone or something outperforming you in the short-term. What matters instead is performance over the long-term, and this is where being diversified and having an appropriate asset allocation show their worth.

The following article from Dimensional Funds illustrates this well (emphasis mine), especially as we near the 10-year anniversary of the market highs before the onset of the Great Recession...

It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis.

Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.

In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as "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" were common front-page news. Reading the news, opening quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who could stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.

It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. 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 of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.

market response to crisis

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.

In the mind of some investors, there is always a "crisis of the day" or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well‑thought‑out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.

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