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Best Days vs. Worst Days - The Effect of Missing Market Extremes

Best Days vs. Worst Days - The Effect of Missing Market Extremes

| November 05, 2019
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With the volatility in the markets recently causing some consternation, I thought it would be wise to revisit a related topic.  I am referring to the concept of seasonality which I discussed in a prior blog post back in May of 2018 (Rules and Myths).  There is also a video on our website that explains it (It Was the Best of Times, It Was the Worst of Times).  This concept has important consequences for portfolio returns and is a subject we should spend more time discussing in depth.  Also, it goes to the core of our investment philosophy and approach in managing client retirement assets. 

First, a history lesson: 

Saturday, October 19th, marked the 32nd anniversary of a day known as Black Monday.  I remember it well; do you?  On that day in 1987, financial markets experienced the most precipitous single-day drop in history.  The Dow Jones Industrial Average (DJIA) had the largest decline in its history – dropping 508 points, or 22.61%.

For readers who are not old enough to remember, the magnitude of Black Monday may be hard to appreciate.  If you’re having trouble putting it into perspective, here are a few points that illustrate just how significant Black Monday was: 

  • With the Dow closing at 27,462 yesterday, a 22.61% decline in the index today would translate to a 6,209 point drop!  Not only is a move of that magnitude unimaginable, but it's actually impossible in today's market, thanks to circuit breakers that were initially put into use in response to the Black Monday drop. 
  • The Dow declined a comparatively modest 12.82% on "Black Tuesday", the crash that preceded the Great Depression.
  • The Dow’s largest single-day decline throughout the 2008 financial crisis was 7.87%.
  • The 22.61% Black Monday decline is more than twice the magnitude of the Dow's largest single-day gain of 11.08% (October 13, 2008).
  • And more anecdotally, a study on stock returns and hospital admissions found that hospital admissions on Black Monday were 5% higher than would have been expected on a normal day.

With this historic market anniversary in mind, today we will revisit a report, courtesy of Nasdaq Dorsey Wright, that looks at the Dow’s 20 best and 20 worst days since 1985.  Looking at the list (below), it quickly becomes apparent that, just as they did in 1987, many of the recent extreme up and down days occur in clusters.

The clustering of extreme days raises the question - what is the net effect of participating in these whip-saw markets?  Though the specifics may be different, we've all heard theories with the same basic premise - a small number of the best market days account for the lion's share of any given year’s return.  And therefore, the theory goes, investors should be invested at all times to avoid missing these days and the occasional sharp downturn (a la Black Monday) is just a fact of life that one needs to endure.  Often, however, these analyses seem to examine the best days in a vacuum –in other words, there is no recognition of the fact that the best days often occur in close temporal proximity to the worst days and therefore if one were to miss the best days, they might also miss the worst days.  And the missing of which of these days has a bigger impact on portfolio returns?  Hint - it's math.  And yes, we have blogged about that (Math Class).  

The most recent addition to the best 20 days illustrates this clustering tendency perfectly.  On December 26, 2018, the Dow notched its 11th best gain since 1985, closing up 4.98% for the day.  However, this banner day came immediately on the heels of the “Christmas Eve Massacre,” when the Dow was down nearly 3% and only three trading days after 12/20/18 when the Dow lost approximately 2%.

So, with a complete data set of "extremes," let’s see how a hypothetical investor would have fared in four different scenarios.  The first is simply buying and holding the Dow from 12/31/84 – 10/16/19, which would have returned 2,128.68%.  The other three scenarios are summarized below:

  • Missing the Worst 20 Days - In the green table below, NDW applied the concept of perfect%. market timing and side-stepping just the 20 worst-performing days in the DJIA.  No doubt about it, the performance would have dramatically improved to the tune of 7,805% in excess of the buy-and-hold option.  Said another way, a $100,000 initial investment would have grown to more than $10 million since 1985. 
  • Missing the Best 20 Days - Taking it the other extreme, what if you had the bad luck to miss the 20 best historical days in the Dow?  In the red table below, you'll find that missing out on these integral days of the market causes an underperformance of approximately 1,549% over the last 32 years.  
  • Missing Both the Best 20 & Worst 20 Days - Now, because we know that nearly half of these severe days in history have come so closely to one another, we wanted to take a look at the effect on performance if you were to miss both the best 20 days and the worst 20 days in the market.  Interestingly, side-stepping all 40 of these days actually provides a better return when compared to simply buying and holding.  This hypothetical portfolio would be up 2,931%, outperforming the buy-and-hold scenario by almost 803%.

 

 

So what does all of this mean to the average investor?  Clearly the first two portfolios represent extremes: losing the race and winning the race.  For the majority of investors, however, it’s not about winning or losing, it's about finishing the race and achieving their personal goals.  Most people don’t enter the market with the goal of always outperforming.  Instead, they are hoping to incrementally build wealth while preserving what they have already saved.  The portfolio that falls right down the middle, missing both the best and worst days, proves that you don't have to ride the volatility roller coaster in order to meet your goals.  Additionally, it shows that market sessions with high volatility have a tendency to occur in clusters; so, while buy and hold may be better than totally missing out on only the 20 best days, the worst days tend to occur in the same volatile periods as the best days.

Investors do not need to stomach the roller coaster ride.  Investors can participate in the upside and control their losses on the downside.  Understanding the supply and demand relationship in everything from individual stocks to asset classes is the key.  Using tools like relative strength, and trend charts gives us a framework to operate within that provides the guidance to recognize how our portfolios should be allocated to avoid absorbing the full impact of the worst days or clusters of days.  This tactical game plan means we won’t experience every best day or worst day in the market, but that’s okay.  What the numbers show is that we can still do very well by running the race our way - staying on even terrain on the way to achieving our goals.

As always, if you have any questions, please do not hesitate to call.  And please share this with others who would benefit.

Until next time, Cheers!

Jim

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

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