With the 10-year anniversary of the bull market upon us, investors have to work a little harder to understand the risks inside their portfolios. While all investment strategies provide details about their performance history, those details get murky beyond ten years. Often times, measures of investment risk are non-existent.
Nearly all investment strategies have some form of documented track record. These are industry standard performance tables that show how the strategy has done over varying time periods. The table below is from an equity mutual fund from a well-known mutual fund company (the specific company and fund doesn’t matter).
The same historical performance is archived in research databases and ultimately presented to the investing public. When you take a look at your investment options within your 401(k), you will likely see this exact same information.
Recency bias tells us that we tend to put a larger weight on recent events and less on those in the distant past. While it’s logical, investors should be aware of how this bias can impact their investing decisions.
A common mistake amongst investors, due to recency bias, is to look at what has recently performed best. A thoughtful investor looks at longer time periods to see how the strategy has done over a full market cycle. With the current cycle having lasted 10 years, it’s hard to evaluate how a strategy will perform in a down market.
Typically funds provide statistics that show how the strategy has done in up and down markets. However, those statistics rarely extend beyond 10 years (if that). For example:
- Down Capture – This number measures how much the strategy declines relative to an index during periods when the market declines.
- Maximum Drawdown – measures the maximum peak-to-trough decline in a strategy over a given period. Assuming you had the worst timing and invested at the highest point, and sold a the lowest point, your loss would be the maximum drawdown.
- Standard Deviation – This number measures the variability of historical returns but is typically measured over just three years.
What’s the point in all this?
If you’re evaluating a potential investment, you may have to do some additional research to see how it has fared during previous downturns. Ideally, you want to focus on a time period that includes the 2008 Financial Crisis. I’m not saying that we should expect a similar event in the near future. However, understanding how an investment performed during that period can help you better understand the investment risks.
The last ten years for the stock market have been amongst the best in history. A large factor is those great returns is the fact that we haven’t experienced a recession since the 2008 Financial Crisis.
In fact, the returns over the last 10 years rank in the top 2% of all 10 year returns dating back to 1960. It’s unrealistic to think that the next ten years will produce similar returns to the last ten. Understanding how your investments will perform during a down market may make a big difference in the not too distant future.