August was not the best month for the stock market

Sam Swift

Sep 10, 2015

By: Sam Swift, CFA, CFP®

August 2015 was not the best month for the stock market. In fact, we just went through the 35th worst month of the past 50 years. This is not something I knew off the top of my head, by the way. That would be borderline psychotic.

Actually, I thought it would be informative to find all the other months that were at least as bad as the one we just had and compare the market periods that followed. I’ve compiled this in the chart below which shows the bad month’s return followed by the subsequent one, three, five, and ten year periods (when possible):

Chart showing bad month’s return followed by the subsequent one, three, five, and ten year periods.

Takeaway #1

Holy cow October 1987 was bad! That included a drop of over 20% in one day on Black Monday!

What does it mean for us?

Not a whole lot other than to remind us of how crazy the market can behave. Could you imagine that happening today? That would be a 3300 point drop on the Dow! I shudder to think of how CNBC would handle that.

Takeaway #2

These severe drops happen completely unpredictably. Here’s a chart with the months from the table marked in red:

Market Drops

Some are clustered around drops, but many happen in the middle of huge bull runs. In fact, 20 of the 35 months preceding the bad months were negative and 15 were positive. For the months immediately following, there were exactly 17 positive and 17 negative returns (we don’t know what September of this year will do yet).

What does it mean for us?

Don’t believe anyone who says they saw this coming or who says it means something for the immediate future. A little over eight percent of all the months I observed had a drop of 5% or more—that conveniently works out to about once every twelve months on average—so we expect this kind of thing to happen. The key is that we don’t know when it will happen and so we plan for that uncertainty and only invest in the stock market when the volatility is irrelevant to us (long-term).

Takeaway #3

The market actually tends to do well following a severe drop. On average, the S&P 500 returned nearly 15% in the year following a month of significant declines. The three years following averaged an 11.48% annual return, the five years following averaged an 11.3% annual return, and the next ten years following averaged 10.36% or just slightly better than the long-term average of the index historically.

What does it mean for us?

Before diving into this data, some may have expected we’d find depressed returns following a bad month—where there’s smoke, there must be fire. Some might have taken the principle of randomness and expected to find a similar mix of positive and negative performance following severely bad months. When you think about this though, the bias towards positive returns makes sense.

After a market drop happens, our expected future return can only increase if we assume that there will always be a premium for holding risky securities (a safe assumption considering all historical evidence confirms this).  If we expect that long-term return to be around 10%, then a short-term market drop means that future returns must increase to achieve the premium.

Most importantly, don’t bail after the drop—the bad part already happened! As one fellow advisor said to me following a bad day last month, “We’re never sure where the bottom is, but we know we’re closer to the next upswing than we were yesterday.”

Takeaway #4

These numbers only represent the S&P 500 which is just a proxy for one asset class—large stocks located in the U.S.

What does it mean for us?

You’ve heard it before, but the long-term diversification benefit from a globally diversified portfolio will only affect these numbers positively. For example, if we use a globally diversified portfolio to measure performance following November 2000 (-7.88%), we get the following:

1-year return: -1.94% (-12.22% in the chart above for just the S&P 500)

3-year return: 6.88% (-5.52%)

5-year return: 11.65% (0.64%)

10-year return: 7.35% (0.81%)

Takeaway #5

Following the severe months listed above, the subsequent year in the market only resulted in negative returns eight times—that’s less than 25% of the time. There were only two bad months that were followed by a three year period that produced negative results. An investor never experienced negative returns over the ensuing five-year and ten-year periods.

What does it mean for us?

We need to reevaluate how we think about risk. In fact, I wrote about this nearly a year ago. The financial industry constantly stresses the importance of long-term returns, but then reverts to short time periods when defining risk. One extreme month—negative or positive—is irrelevant to a long-term plan that is saving for ten, twenty, or thirty years down the road. If our timeframe for our goal is a year from now, then by all means we should care about short-term volatility (and should have some fixed income allocation to cover those needs so our stock portfolio can still be intended for the long-term). If our time frame is greater than ten years, then our least “risky” portfolio is a globally diversified portfolio of stocks.

Taken all together, this data just confirms that what we’re doing is what we should continue to do. Set an allocation that’s appropriate for our unique situation and goals, diversify globally and inexpensively, and don’t let short-term noise throw us off course.

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