The Chart They Don't Show You

If you’ve had the pleasure of interacting with wealth managers for a long enough time, you are very likely to have come across some variant of the phrase “it’s time in the market, not timing the market that matters for long-term return”.  This dictum is usually accompanied by a chart showing how much worse than the market you would have done if you just missed out on the x number of best days or months.  However, as is often the case with anything used in marketing material, it is at best an oversimplification and at worst misleading.  I was reminded of this while reading the June Risk Update from risk management specialists Convex Strategies.

https://convex-strategies.com/2023/07/13/risk-update-june-2023-one-thing/.

Firstly, let’s address the blindingly obvious: if you take away all the best periods, investments don’t tend to do as well.  Thanks.  However Convex Strategies look at the other side of the coin.  The chart below from the report referenced above, shows the total return on the S&P 500 since 1983 and then stripping out both the 10 best and 10 worst months.

S&P 500 Returns 40yrs (grey) – Less 10 Best Months (red) and Less 10 Worst Months (blue)

Source: Convex Strategies

The thing that is obvious is that the impact of the worst months is much more significant than the impact of the best months.  This is the fat left tail on the return distribution.  What is less obvious is that of the 480 months in the sample, the impact of the middle 460 months is modest relative to the top and bottom 2% of the sample.  It’s the tails that matter.

The reason wealth managers focus on not missing out on the best months is that this is really easy to do.  What is much harder, is mitigating the hit from the inevitable bad months.  Said differently, big drawdowns matter a lot to long-term returns.  Quoting from the report “The further a realized return diverges from the mean, the more relevant its impact on geometric compounding.”  If you experience a big drawdown, the maths is just really unforgiving.  Down 50%, needs up 100% to get back to square one.  This is without the psychological component of drawdowns leading to bad decisions compounding the problem.

Sophisticated hedging strategies can help in this regard, however for most investors, better diversification to include return streams uncorrelated to the core financial assets is a good place to start.