Tariffs and their potential consequences on global economics and trade triggered a stock market pullback. As of 22 Apr, the S&P 500 Index has tanked more than 15% from its peak achieved in mid-February. Fears spilt over from Wall Street to the rest of the world. World equities also retreated about 10% during the same period.

Markets are flirting with entering bear market territory, but this is hardly the whole picture of how the machinery works. We analyse the data of past drawdowns, their time to recover, and returns after the fall. The pain of loss is real, but history tells us that there is a lot to gain from situations like this as well.

How common are corrections of 10% or more?

Since 1970, there have been 19 instances where the S&P 500 Index has dropped by more than 10%, 12 instances of drops of more than 15%, 16 instances of drops of more than 20%, and four instances of drops of more than 30%.

For global markets, the situation is similar: 17, 12, seven, and four instances of drops more than 10%, 15%, 20% and 30% respectively.

The table below shows the time to recover to previous highs from these drops. Interestingly, the speed of recovery has become faster in recent history, perhaps with increased information transparency and access to markets.

How do investors do after a stock market correction of 15% or more? 

Looking at the forward total returns after a drawdown of 15% or more, the results look very favourable for investors, especially over longer time horizons. The chances of being positive are high, especially if more diversified.

These statistics do not apply to any specific stock, but are the case if you invest in a diversified portfolio of the overall stock market, like the Endowus Core-Flagship 100% Equities Portfolio, which gives you exposure to over 12,000 stocks across developed and emerging markets at low cost. 

Timing the bounce back is hard. You can invest when the market is down 15%, and it may go down another 15% before it begins its recovery. What is more important is that when you invest, you have the time horizon for your goal, and a volatility tolerance that is associated with investing in the stock market. If you have these ingredients, your probability of success is high. 

Why does the stock market tend to go up? 

Statistics aside, it is important to philosophically understand what it means to invest in stocks (equities). When you own stocks, you are a shareholder of companies that are trying to create shareholder value by selling goods and services. 

Very simplistically, if you believe that the world’s population growth, technology innovation, efficiency gains, and demands for goods and services will give companies the opportunity to grow and increase shareholder value over time, then owning stocks long term is very reasonable to participate in the growth of companies. 

Stocks have a higher expected return than bonds because if a company goes bankrupt, the bondholders are paid back before the stockholders get anything at all. Bonds are paid a coupon or a set amount as long as the company exists for the duration of that bond. Bonds do not participate in the upside of shareholder value and therefore have a lower expected return.

Understanding the time horizon and risk tolerance of each of your specific goals should determine whether stocks, bonds or a combination of the two makes the most sense for each of your specific goals. 

Downward trending markets tend to be short-lived when compared to upward trending markets 

Cyclical downturn events typically result in the largest maximum drawdowns and longest recovery times, while non-economic events often see the fastest rates of decline. Interestingly, in 16 out of 31 recessions since the Civil War, stock market returns have been positive.

Factors influencing recovery speed include economic conditions and policy stability. Interestingly, periods of high uncertainty have often been followed by strong market performance, with average returns exceeding 20% in the subsequent year. This underscores the importance of maintaining a long-term perspective during market downturns.

Another unspoken truth is that since 1954, declines of 20% or more have occurred about once every six years. However, bull markets have historically lasted longer (52.8 months on average) and delivered higher cumulative returns (155.6%) compared to bear markets. Despite corrections happening every one or two years, markets have consistently rebounded.

This long-term resilience underscores the importance of maintaining a well-diversified portfolio aligned with your investment horizon.

3 Reasons why long-term investors shouldn't fear downturns

"I have time in the market"

Ample time warrants the ability to stomach fluctuations and benefit from compound growth. Therefore, long-term horizons (over 10 years) allow for higher equity exposure, capitalising on the historically higher returns of stocks over extended periods. This is given that the equity allocation is well diversified.

The historical patterns of US and global equity indices show that, even as indices suffer double-digit losses, chances are that the recovery that comes after would absorb the loss and deliver a long-term gain.

Certainly, if your financial goal is due within a shorter term (1 to 3 years), equities may not be the most suitable vehicle to get to the desired outcome. Short-term goals should stay focused on capital preservation, favouring cash-like investments such as money market funds or cash management solutions to minimise loss risk. For medium-term objectives, a balanced approach combining stocks and bonds can offer growth potential while managing volatility, such as the Endowus Flagship 60/40 Portfolios.

In short, your investment time horizon is the centrepiece of your strategy and risk tolerance. As your time horizon shifts, it's vital to reassess and adjust your portfolio accordingly, gradually reducing risk as you approach your target date to safeguard your investments against potential market downturns. A good barometer of your risk tolerance is whether you feel comfortable with your financial outlook based on the current volatility of the market. 

"I have dollar-cost averaging set up"

Dodging the declines can risk missing the rebounds. Dollar-cost averaging can be effective to invest consistently regardless of market conditions.

Even the markets are down 15%, and further, by investing a fixed amount at regular intervals, you essentially buy more shares when prices are lower and fewer when they are higher. This disciplined approach smooths out the average purchase cost over time and reduces the risk of loss from investing a lump sum.

When combined with a long investment horizon, dollar-cost averaging allows investors to capitalise on the market's upward trajectory over time, too. Benefits of such consistency can be felt over the long term with the power of compounding, rewarding patient and disciplined investors.

"My portfolio is auto-rebalanced"

Regularly rebalance your portfolio to maintain your desired asset allocation and risk profile. By adjusting your asset allocation to maintain your desired risk profile, you can potentially capitalise on undervalued assets while managing overall portfolio risk.

Regularly rebalancing your portfolio helps remove emotion from the investment process, allowing you to systematically buy low and sell high during both market upturns and downturns.

During market declines, rebalancing prompts you to sell underperforming assets and buy more of the discounted assets. Conversely, when asset prices are up, rebalancing trims your exposure to the outperforming assets and reinvests the proceeds into underperforming ones, effectively locking in gains. Endowus has an auto-rebalancing function built into its portfolios, automatically rebalancing the asset allocation based on your selected risk profile, removing the need for you to monitor and manually assess your asset allocation. 

This disciplined approach prevents you from chasing recent winners or panicking during volatility.

Invest with a scientific and evidence-based strategy

The fear of loss often overshadows the potential for gain. This phenomenon, known as loss aversion in behavioural economics, unfortunately, makes us a worse investor than we want to be.

We do not necessarily have to be confined by the bias to perform the same way. The above examples of a drawdown, as well as their subsequent recovery potential, should help you ride through difficult times.

Historical data and recovery patterns show that while market corrections are inevitable, they are often followed by periods of recovery and growth. This evidence-based approach helps combat the cognitive bias of loss aversion.

Successful investors focus on rational, prudent strategies to prevent falling into common traps arising from emotional influences on their judgements. By trying to time the market or worse, react to it, most investors tend to lose more than if they had remained disciplined with their financial goals. 

Lastly, equities as an asset class is intrinsically associated with better performance, but it might not be suitable for everyone. In reviewing your personal investing strategy, your time horizon and risk tolerance remain pivotal in determining what you should invest in. 

What does this history tell us about navigating volatile markets? Mainly, that they are worth navigating.