The Best of Times and the Worst of Times

Investing in the stock market can be greatly rewarding, but it requires patience and nerves of steel

Paul Kaplan 10 December, 2018 | 6:00PM

At the end of January 1956, if you had invested a single Canadian dollar in a fund that tracks the S&P/TSX Composite index, by October 2018, you would have about $208. That’s an annual rate of return of about 8.9%.

From the perspective of potential reward, stocks can make for great investment. But those impressive results can come with a price. The historical record shows that along the way to a 208-fold increase in value, an investor in the Canadian equity market would have had to endure losses of over 43% over a two-year period, and then again over a 9-month period.

This goes to show, that in order to reap the benefits of the “best of times,” an investor must endure the “worst of times.” Let’s start with the worst of times.

The Worst of Times

The blue curve in the chart below labeled “Cumulative Value” shows the path of a dollar invested in the S&P/TSX Composite index at the end of January 1956, assuming full reinvestment of dividends and no taxes. The vertical axis is on a logarithmic scale so that the distance between $10 and $100 is the same as between $1 and $10. In this way, a constant rate of growth would make the cumulative value curve a straight line.

Growth of $1 Invested in the S&P/TSX Composite Index: January 1956—October 2018

As you can see, along the way to $208 dollars, the cumulative value of the S&P/TSX Composite index took some large hits, sometimes called drawdowns. As the chart shows, the worst drawdowns are associated with macroeconomic events such as the global financial crisis of 2008.

To show the timing and magnitude of drawdowns, I included the red curve, labeled “Peak Cumulative Value.” Each month, this curve shows the highest cumulative value to date. When the cumulative value is rising above a previous peak, it is the same as the cumulative value. But when the cumulative value dips below its most recent peak, it is a straight line.

At some point, the cumulative value stops dropping and starts rising and eventually gets back to and eventually surpasses its previous value. This sequence of events appears on the chart as the v-shaped segments of the cumulative curve below the straight segments of the peak cumulative value curve.

The table below summarizes some of the worst drawdowns over the period January 1956—October 2018:

Events Peak Trough Decline Recovery
Global Financial Crisis May 2008 Feb 2009 43.3% Feb 2011
Dot Com bust Aug 2000 Sep 2002 43.2% Jul 2005
Volcker Bear Market Jun 1981 Jun 1982 39.2% Apr 1983
Oil Crisis/Nixon Ends Gold Standard Oct 1973 Sep 1974 35% Apr 1978
Asian Crisis/Russian Debt Default Apr 1998 Aug 1998 27.5% Nov 1999
U.S. Slowdown/Bond Yields Rise Sharply May 1957 Dec 1957 26.9% Apr 1959
Black Monday Jul 1987 Nov 1987 25.4% Jan 1972
Iraq Invades Kuwait Dec 1989 Oct 1990 20.1% Mar 1993
Source: Morningstar

It is sobering that the two worst drawdowns are also the most recent. Both the 2008 global financial crisis and the 2001 dot com bust cost Canadian stock market investors over 43%.

Daniel Kahneman said that stock investors need to have nerves of steel, so that they stay the course during the market’s worst periods. The historical record of the Canadian stock market shows that that is indeed the case.

However, successful investors need more than just nerves of steel. They also need to have a great deal of patience. To see how much patience a successful investor needs, I found the longest period over which the cumulative value was lower at the end of the period than at the beginning.

This turns out to be June 2000 through February 2009, a period of 8 years and 8 months. To highlight this period, I colored this segment of the cumulative value curve gray. The period includes the drop associated with dot com bust, the recovery from that period and subsequent drop associated with the global financial crisis. After all of that, the cumulative value was down 4.7% from where it was in June 2000.

In the next month, March 2009, the market return was about 7.8%, undoing the previous loss. This was one of the highest monthly returns over the entire period January 1956—October 2018 that make stock investing ultimately payoff. Which brings us to the “best of times.”

The Best of Times

The fact is, if an investor has patience and nerves of steel, investing in stocks can pay off handsomely. This is because of the positive returns that not only make up for the losses of the negative returns, but also those that provide a positive overall return.

The latter set of returns is usually small in number. To see how many exactly, I sorted the monthly returns on the S&P/TSX Composite index from highest to lowest and removed them one at a time until the cumulative value on the remaining dips below 1. This turns out to be the highest 69 monthly returns which range from 16.5% (January 1975) to 5.8% (June 1977). This is 69 out of 773 months, or about 9% of the time.

The returns necessary for success are somewhat rare, which goes to shows how important it is to stick with the market, no matter how painful. Investors should not try to time the market. Errors in market timing could be quite costly as they could led to missing the highest returns.

Expectedly, the timing of the 69 monthly returns that lead to the ultimate triumph of stock investing occurs mainly during periods of recovery from drawdowns and periods of climbing to new peaks.

Conclusions

While the stock market can be quite rewarding, it can also be quite risky. To be successful, a stock market investor needs to exercise patience and have nerves of steel to withstand the worst of times. But if an investor can stay the course and not try to time the market, the best of times should more than outweigh the worst of times. However, this assumes that the investor is in the stock market for the long run. Short-run investors need to look elsewhere for returns.

About Author

Paul Kaplan

Paul Kaplan  Paul Kaplan is Director of Research for Morningstar Canada.