Welcome to the Big Bounce

Psychology, Portfolio Talk

I don’t know about you, but the last few months have been some of the wildest and most newsworthy I can remember. From a global pandemic and ongoing social unrest on one end to an incredibly inspiring SpaceX launch and emerging hope for a better world on the other, the roller-coaster of emotions has been all over the map. It’s unpredictable, intense, and at times utterly exhausting.

And the markets have clearly mirrored that crazy ride. It seems like only yesterday that I was writing an article cataloging one of the single worst months to invest on record, but the market has since roared back far faster than even the most optimistic investors expected. That encouraging development seems to have changed investing mindsets a bit, spurring a curious reader to pose an interesting forward-looking question:

What are the portfolios that tend to do better after a crisis?

While I don’t have a functioning crystal ball, I do have a ton of historical data at my fingertips. So let’s dig in and see what we can learn about portfolio recoveries.

Equal and opposite reactions

To answer that question, let’s start where we left off a few months ago when things looked a lot more dire. In Asset Allocation in the Most Painful Month, I talked about the drawdowns for each portfolio from the stock peak on February 19th to the close of the market 30 days later on March 20th in the throes of the unfolding COVID-19 pandemic. And it wasn’t pretty. Sure, some portfolios handled it better than others. But there was no escape from the pain.

While we had no idea where things would go from there, as luck would have it that timeframe just happens to capture almost precisely the maximum stock market drawdown this year. And the market bounce since that date has been nothing short of astounding given the circumstances. To illustrate that, here is the total return for each portfolio in the following 2.5 months from March 21st through June 5th.

Note that I kept the portfolio order the same as the first one ranked by drawdowns so it’s easy to compare both charts. This way it’s easy to see lesson #1 in portfolio recoveries:

The height of the bounce is proportional to the depth of the fall.

Basically, both losses and gains are related to overall volatility. Portfolios usually don’t change their character overnight, and big gains go hand-in-hand with big losses.

Even so, the thing that seems to have caught people off guard is the height of that bounce. While the timeframe of the second chart is more than twice that of the first, few expected the total stock market to gain 45% so quickly (compared to the initial 33% loss) when the underlying issues that caused the drop in the first place are still around. And the big numbers have caused a bit of renewed exuberance in the market where it seems like some investors are suddenly clamoring to pile into the portfolios with the highest recent returns.

You can’t look at gains in a vacuum

But as I’ve mentioned time and time again, numbers taken out of context often lead you to make poor decisions. In this case, you have to remember that those big gains came immediately after a big loss. Expand the analysis to the full timeframe from February 19th to June 5th spanning both the long fall and the big bounce, and the results look like this:

Again, this has the same order of portfolios but gives a very different impression. Despite having more gains after the bounce than losses before, most portfolios are still down from their February peak. And the ones back to normal or already posting new highs actually have the lowest recent gains. They just had a much shallower hole to climb out of. Which leads us to lesson #2 in portfolio recoveries:

Big losses require even bigger gains to break even.

Returns percentages are compounded, and losses from a higher starting point have a bigger effect on your account balance than the same percentage gain from a lower starting point. Keep that lesson in mind every time you evaluate recent returns. That huge 45% gain for the stock market may look like the best choice on paper, but the more meager 12% gain for the Permanent Portfolio investor who planned ahead and just sat tight actually resulted in a higher total return in the end. Fast growth in a recovery is great, but not losing money in the first place is just as important.

The measurable benefits of persistence

To appreciate how much the market rebounded in just over two months time, here is the big one month drop and the total return including the subsequent recovery combined into one image:

What a difference a few months make! When it seemed like the entire world was falling apart, nobody predicted that the steep losses would evaporate like that. Anyone who stayed the course must be very satisfied with the results.

Unfortunately that’s often a lot harder than it sounds, and I know for a fact that lots of people sold in fear at exactly the worst time. I totally understand your emotions then and your frustrations now. When you know that you could be the red or blue column but you locked in the gray, that’s a tough pill to swallow. In fact, that’s a good lesson #3:

People who sell when times are bad miss out on any recovery.

While you intuitively think you’re decreasing risk of further loss, you’re most likely increasing the chance that you’ll end up with less money in the long run.

It’s ok. We’ve all done it at some point. So try turning the negative into a positive. Find a portfolio you can stick with even when times are tough, and you’ll keep yourself positioned to benefit from the inevitable recovery while nervous active traders are still sitting on the sideline wondering what to do next.

Not every ball bounces the same way

All that said, I do understand that the events surrounding this particular crash and recovery are pretty unique. I also know that different portfolios may struggle at very different times. So let’s blow this up and think big-picture. If we really want to study how different portfolios recover from big losses, we’re gonna need a higher drop.

For each portfolio on the site, I first measured the deepest inflation-adjusted compound drawdown since 1970 (using year-end data). To capture the recovery behavior, I then found the annual real return for the first year after the bottom for each individual portfolio. And finally, I calculated the resulting portfolio drawdown from that initial highpoint to the end of the first recovery year.

Plotting both drawdowns on the same chart is a good way to gage the “bounciness” of any portfolio after the biggest loss for that portfolio on record. I wasn’t sure what to expect, and frankly the results surprised me.

The first thing I noticed is that the 1-year recovery was pretty similar in most portfolios from the Sandwich Portfolio to the left. Most gained back about a quarter to a third of their losses one year after the floor. It definitely demonstrates just how remarkable the most recent recovery looks in a historical sense, and it also illustrates the lasting pain of the systemic issues that caused drawdowns even deeper than we’ve experienced this year.

But move to the right of the chart, and the speedy recoveries of several portfolios really stand out. Not only did asset allocations like the 7twelve Portfolio, Pinwheel Portfolio, All Seasons Portfolio, Permanent Portfolio, and Golden Butterfly not lose as much as the pack, but they also recovered way faster and posted much better end returns. Think of the portfolios on the left like a bowling ball dropped from a rooftop and the ones on the right like a super bounce ball dropped from a tabletop. Which would bounce higher? Not everything is about the height of the fall.

Another way to study portfolio recovery is to look at the Drawdowns charts. For example, here are a few different portfolios along the spectrum:

In this case, ignore the red lines and look at the grey fill below them. Imagine that area as a piece of fabric. Losses for the total stock market are like tossing a ball into a soft down mattress, while losses for the Golden Butterfly are like jumping on a taut trampoline. The stock market can take more than a decade to recover from big drawdowns, while the Golden Butterfly completely bounced back just a year after its worst drawdown ever.

Which leads to a fourth lesson about portfolio recoveries that is new even to me:

Some portfolios are bouncier than others and recover more quickly after a big loss.

While the overall magnitude of a recovery is generally proportional to the loss, the response time can be very different for each asset allocation. When faced with their own worst case scenarios, bouncy portfolios have an interesting quality of springing back very quickly compared to their more spongy counterparts. Which of course makes it a lot easier to trust your investments and stay the course.

Exactly how that works is worth further study, but clearly some portfolios are just more resilient to market turmoil than others. And that inherent robustness seems to extend beyond the initial drawdowns and to the resulting recoveries as well.

It’s all in the strategy

Regardless of the precise mechanisms driving portfolio recoveries, the results are indeed pretty interesting and a valuable lesson for anyone thinking about how to best manage their money. Recapping the high points of what we learned:

The portfolios that lose the most also gain the most, but larger losses dig a deeper hole that you need even bigger gains to escape. You have to fight your instincts and stay invested to capture the recovery, and some portfolios recover more quickly than others.

Note that this summary really spans the full spectrum of personal finance from risk management and pain tolerance and all the way to portfolio theory. Every investor and portfolio is different, so the asset allocation that best works for you personally may not be the same as the one that works for me. But hopefully this article will help you think about the problem a little differently, and Portfolio Charts has lots of tools to help you explore new ideas on your own.

If you thought the big market drop was an emotional ride, are you ready for the big bounce? With the right portfolio the entire experience can be a lot less stressful and more fun than you might think. All you have to do is find it and stay the course. So stop chasing fleeting recent recovery returns that you know you’ll never be able to effectively time, and start thinking about how you might invest for the long run where your intelligently-built asset allocation does all of the work for you.

And enjoy the ride!

Are you intrigued by the concept of bouncy portfolios?