One topic is cropping up a lot in my conversations with investors. It is, you may not be surprised to read as the bull market approaches its third birthday, a variant of: ‘are the good times about to end?’ It’s a good question but impossible to answer. Which makes another one possibly more interesting: ‘how much does it matter?’
This is less stupid than it sounds. Of course, we’d all like to avoid market corrections, especially big ones that take a meaningful chunk out of our savings or upset our retirement plans. But given how difficult it is to time the tops and bottoms of the market cycle, it is perhaps more useful to simply understand the risks we are taking by staying or going. And to ask ourselves how we will feel if we call it wrong.
How much these kinds of market falls matter is largely a function of whether you have the liquidity and time to ride them out.
Fortunately for me, three London Business School professors - Marsh, Dimson and Staunton - have crunched the relevant numbers on behalf of UBS’s Global Investment Returns Yearbook. To start with, they have provided some context - the scorecard of the six worst episodes for investors during 125 years of market history from 1900 to 2024.
These periods of shocking investment returns - what people are thinking about when they whisper the crash word - were associated with two world wars, the Great Depression, the 1970s oil shock, the dot.com bust and the financial crisis. Even if you disregard the near total losses incurred by the losers in the two global conflicts, the evisceration of wealth in these periods was dramatic - as much as 80pc in real terms in the case of Wall Street after the 1929 crash.
How much these kinds of market falls matter is largely a function of whether you have the liquidity and time to ride them out. The Wall Street crash saw the longest wait until a full recovery had been made - of fifteen and a half years. The other peacetime mega bear markets were quicker to heal. Only two years in nominal terms but ten, adjusted for inflation, during the 1970s bear market. Seven and a half years after the dot.com bust and just over five years after the financial crisis.
These figures all relate to the US market. For American investors, that period after the Wall Street crash is as bad as it got. There’s never been a period of 16 years or longer when you haven’t made money in US shares, even if you had the misfortune to buy right at the top.
Diversification can help protect your portfolio from the worst ravages of a correction.
For non-US investors the picture is not quite so reassuring. Many countries, including the UK, have always given you a positive return if you held on for 22 years or more. But there are seven countries, including some pretty mainstream investment destinations like Germany, Japan and Italy, for which the shortest period that would guarantee a positive return from shares has been more than half a century.
So, the answer to whether a big market correction matters is: yes, especially if you are not American and not young. For the rest of us, the potential damage to our financial outcomes is inversely proportionate to our investing timescale. By the time you get to my age, the possibility of a life-changing downturn concentrates the mind.
One of the things I find myself saying when discussing the market’s ups and downs is that diversification can help protect your portfolio from the worst ravages of a correction. The historical evidence on that is mixed.
There is certainly a wide dispersion of returns during the worst periods. For example, during the First World War, while German shares fell by 66 per cent, those in Japan rose by the same margin. British shares were down 36 per cent between 1914 and 1918, but those in the US only fell by 18 per cent.
The more recent peacetime bear markets have tended to be more indiscriminate, however. In 2008, during the financial crisis, US shares fell by 38 per cent, while those in the UK were 33 per cent down and 43 per cent lower in Germany. Japan was off 41 per cent. So not a lot of protection from spreading your bets.
In fact, there is some evidence that correlations rise during periods of crisis and in bear markets. You might say, diversification lets you down when you need it most.
I’d like to think that the much higher valuations in the US market, and the fact that the focus of the artificial intelligence (AI) bubble, if that is what it is, is in America, make things different this time. A tech-focused US market correction could have less of an impact in some of the world’s less stretched markets, like our own in the UK and some emerging markets. But I don’t think I’d want to rely on this to bail me out if the AI boom does end badly.
In the long run, stock market investors are rewarded for accepting the risk of investing in a volatile asset class like equities. The reward is measured by the extra return that stock market investors can expect over time compared to those leaving their money in cash or investing in bonds. This equity risk premium has averaged 8 per cent a year since 1900 in America and 6 per cent a year in the UK.
Which is fine if time is on your side. For my young adult kids, my advice remains the same. Be diversified, save as much as you can afford and put your faith in the stock market. For the rest of us, especially those approaching retirement, protecting our gains after several years of strong returns is more than theoretical. If someone had told me during the Covid lockdown that I could double my money in a few years and then lock in a four or five percent return thereafter, I might well have bitten their hand off. I’m not surprised that it’s what our investors want to talk about.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
