I’ve been thinking a lot lately about what investors should expect from financial markets and how to deal with the inevitable emotions that come from volatility and downturns in markets.
Over the past two months we have seen markets jittery once again, with the S&P/ASX300 retreating by -6.18% in October and again by -2.75% in November. This is in contrast to the strong returns we have enjoyed for the past five years as outlined in the table below.
Not surprisingly, investors react differently during these periods of volatility. We see long-term, seasoned investors barely flinch when markets drop by 10 per cent – perhaps this is because they’ve experienced it all before.
Last week I spoke to newer investor who was feeling quite concerned – the tone of the conversation was ‘I never signed up for this’. We’re always searching for better ways to explain markets and this is where the rule of 70-20-10 was born.
The graphic below shows a distribution of annual returns from the Australian share market measured by the S&P/ASX All Ordinaries index for the last 118 years. It shows that in 83 of the years (70% of the time), returns were distributed between zero and 30 per cent.
Then we look at the negative returns. There were 22 years where returns were between zero and -50 percent. This represents a negative return about 20 per cent of the time, that is one in every five years.
Finally, we have the remaining 13 years where the annual share market returns are better than 30 percent, and as high as 70 percent. This accounts for the final 10 per cent.
So, there you have the rule of 70-20-10. When it comes to investing in the share market it seems you’re going to be happy about 70 per cent of the time. Another 20 per cent of the time you will need to steel yourself as returns turn negative. During these years, (about 3 per cent of the time), you will have returns worse than -20 per cent and your resolve may be sorely tested.
Finally, there’s the glory years where returns are greater than 30 per cent for the year. Historically this has occurred in 13 of the last 118 years.
Australian Share Market Returns S&P/ASX All Ordinaries Index^ – Dec 1900 – Dec 2017
While the past is no guide to future returns the 70-20-10 rule does make sense in helping us temper our reactions to a market downturn. First, we should expect a negative return in one out of every five years. Most likely, the downturn will deliver a return of between zero and -10 per cent, while on a few occasions during our lifetimes the negative returns will be more severe.
More often than not the optimists win!
A decision to invest in in the financial market is individual and will need to consider the investor’s return and risk objectives. However, once a decision is made to invest in the stock market, a disciplined, long term view is likely a more prudent course of action than being concerned about new market highs.