Tuesday, May 22, 2018

Investors seem to forget that markets can and will go down. It's called risk amnesia

Prolonged bull markets with periods of low volatility can create risk complacency and even "risk amnesia." Any subsequent market correction and/or spike in volatility often shakes investors out of their state of complacency and ignites a sense of fear of what they may have temporarily forgotten �� that markets can and will go down.

While market drawdowns are inevitable and necessary for healthy markets, investors don't exactly jump for joy when one occurs. Because loss aversion is such a strong emotional driver, it is typical for many investors to quickly panic.

Market crash H. Armstrong Roberts/ClassicStock | Getty Images

However, corrections offer an opportunity to evaluate risk and how well positioned they are for an eventual bear market.

By comparing the intensity, recovery and duration of corrections and bear markets and their impacts on investors, we can assess where risk management efforts should focus.

Investing opens investors up to the possibility of losses �� but not all losses are equal. Understanding the differences between a correction and a bear market may help investors better handle or prepare for them.

In the past 20 years, the S&P 500 Index has experienced five corrections (not including the corrections occurring as part of the bear markets) and two bear markets.

Corrections are often defined as losses in market value exceeding 10 percent but less than 20 percent and happen from a market high. Corrections have historically lasted from between a few weeks to a few months.

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Bear markets are defined as losses in market value of 20 percent or more and have historically lasted several months to several years. The losses experienced in bear markets are more intense and require longer recovery periods on average than corrections.

The intensity of the drawdown measures how much market value was lost. Over the last 20 years, the most intense correction delivered a 19 percent drawdown, and the least intense corrections created a market value loss of about 12 percent to 13 percent.

By comparison, the magnitude or intensity of losses during bear markets are often more difficult for investors to stomach. Although a bear market is defined as losses in value of more than 20 percent, the two in the past 20 years were more than ��47 percent �� more than double the losses caused by the worst corrections.

The intensity and effects of a bear market are much more painful, especially when we consider time of recovery. Recovery time refers to how long it takes for the market to recoup its losses and return to pre-fall levels. Mathematically speaking, the larger the loss, the larger the gain needed to recover.

The ��13 percent drawdown of the 2015-16 correction took about two months to recover, while the ��19 percent correction in 1998 took only about three months. The ��11 percent drop in 2000, though, took almost five months to recover.

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Despite the discrepancy between corrections' drawdowns and recovery times over the last 20 years, they all took less than half a year to recover. The recovery for the two bear markets of the 21st century, however, required years.

The duration of a drawdown includes the total length of time the market took to fall from a peak to the trough and the length of time to recover the losses back to the pre-drawdown level.

The bear market during the dot-com bust of 2000��2002 was a slightly smaller drawdown than the bear market during the financial crisis of 2008��2009, but its duration was much longer. Neither was much fun for investors.

Generally speaking, corrections take less time overall, from fall to recovery, with the duration of corrections lasting less than a year and bear markets going beyond four years. If, on average, it takes less than a year for investors to move on from a correction, are they really worth all the fuss?

"In an industry too often focused on short-term returns, corrections can cause shortsighted reactions that negatively impact long-term plans."

Corrections are often a wake-up call for investors to consider risk. But if investors and their portfolios are unable to withstand a 10 percent correction, are they prepared for the possibility of an actual bear market?

In an industry too often focused on short-term returns, corrections can cause shortsighted reactions that negatively impact long-term plans. Corrections come and go, with market losses and recoveries occurring within the span of weeks or months. As such, corrections are, generally speaking, a blip on the investment journey: They don't derail investors from their financial goals.

Bear markets cause more significant losses that can often take years to recover from and can be plan-altering and life-changing, both financially and emotionally.

Because one cannot invest in risk assets and protect against both corrections and bear markets at the same time, risk-management efforts should focus more on bear markets rather than corrections.

�� By Micah Wakefield, director of research and product development at Swan Global Investments

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