Should You Invest in Down Markets?

Most seasoned investors know, on an intellectual basis, that they capture what Ben Graham calls a “basic advantage” when they stand pat, and even put new money to work after the market has lost ground. But, the decision to invest — the pledging of hard-earned dollars — does not take place in the mind, but rather, in the gut.

When the market hits a rough patch in response to news about war, recession, home prices or unemployment, many investors are challenged to tune out that nagging little doomsayer ever chanting “it’s different this time.”

Truly, it takes a gutsy investor to shake off worry and stand firmly entrenched in investments when they have lost value; in some cases, a lot of value. In Graham’s view, this is capitalizing on that basic advantage — holding on for the long-term expected returns that we rely on capitalism to deliver.

Capitalism is alive and well. It is not suffering and it is not ill. It is simply doing its job. It is absorbing the decisions of all free market participants as they digest news about local, national and global events that occur on an ongoing basis — every minute of every day. These free markets rise and fall as investors express their confidence in the markets as they are impacted by such events.

Most often, the global markets absorb similar degrees of positive and negative news. As a result, markets are not significantly impacted in the short-term one way or the other, and they continue their slow and relatively steady increase over time. However, once every few years, the markets receive really big news that sends them much higher or much lower. Lately, credit worries have dominated the news, and the markets have responded negatively, with both the Dow and the S&P having reached the cusp of bear market territory with nearly 20% declines from their highs.

Those investors who panic and sell in such times will likely look back to realize that they permitted themselves to be stampeded, to borrow Graham’s phrase. In other words, their guts couldn't take it, and they lost faith in the markets, reacting to the illogical fear that there will be no future good news to move the markets forward.

Take a look at the chart below, it shows that over the past 69 years, capitalism has delivered 21 significant market downturns. Certainly, human nature being what it is, the sentiment “it’s different this time” was just as difficult to shake off during each of those events as it is right now. But, history shows that those who had the guts to put their faith and trust in long-term capitalism were ultimately rewarded.

(For better quality and full disclosure for the chart, please click to see the PDF document)

From August 1939 through July 2008, the returns of an all-equity, globally diversified Index Portfolio 100 were the most volatile of the Index Portfolios represented. They also earned higher overall returns. Index Portfolios 50 and 5 enjoyed smoother rides, with significant allocations to fixed income dampening both volatility and long-term returns. The lesson here is clear, higher returns come with higher volatility.

Not all portfolios with similar levels of volatility carry the same expected returns, however. If you look at the chart carefully, you will see that IP 100 and the S&P 500 share similar volatility, but the returns of IP 100 are far greater than those of the S&P 500. If risk and return are so carefully intertwined, how can there be such disparity in returns between these two investments? The answer to this question is revealed in an important investing concept brought to light by Eugene Fama and Kenneth French. The two economists determined that substantial, but risk-appropriate allocations to both small and value stocks will increase the expected returns of a portfolio. The S&P 500 does not offer this type of exposure as it invests in just 500 large-cap U.S. companies. An investment in only small and value, however, carries significantly more risk than the S&P 500. IP 100 dampens this risk by investing across 11 asset classes that include investments in about 17,000 companies world-wide. Looking at the chart, you will see that this tilt toward small and value with global asset class diversification has enabled IFA investors to capture substantially higher returns at a similar level of risk. Over the 69-year timeframe, a dollar invested in the S&P 500 grew to about $1,200 while a dollar invested in IP 100 would have earned nearly $10,000. Merton Miller was right: "Diversification is your buddy."

In light of this important historical data regarding risk, return, time and diversification, your intellectual side is undoubtedly keenly aware of the importance of staying invested and investing, despite market conditions. But, intellect rarely prevails when it conflicts with the gut. So, for just a moment, imagine, if you can, a world without capitalism. Imagine a scenario in which 17,000 publicly-traded businesses around the world cease to profitably deliver the products and services that we all consume and use. Imagine the world’s markets failing — and all at once. Finally, imagine what your money would be worth if all of that actually came to pass…

If, like us, you simply cannot imagine the demise of the world’s markets, then follow your gut: Buy and hold capitalism, it works.

In tough markets, many investors find it difficult to adhere to an investing discipline, or to maintain a sound perspective that maximizes appropriate exposure to stock market risk to achieve long-term expected returns. Index Funds Advisors can help. Index Funds Advisors provides expertise in measuring and quantifying risk capacity for the long-term investment needs of individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn returns commensurate with the risks they take. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost, tax managed and efficient. To learn how you can Invest and Relax, call 888-643-3133 to speak with an Investment Advisor Representative, or go to ifa.com.