Imagine for a moment that you are presented with the following investment opportunity.

For your outlay of capital, you are expected to earn approximately 80% over the next five years. This return is not guaranteed of course, but there is a 95% probability you’ll at least earn a positive return. Should the economy or some other exogenous factor adversely impact results, leading to a negative return (a 5% chance), the investment’s expected worst-case is a 25% loss.

Additionally, there is no requirement to redeem at any time, even after the five years are up, though you certainly can. It should be noted that any below average return during your first five-year holding period typically translates into significantly higher returns over the next five years.

Does this sound like a five-year commitment you’d be willing to make? An expected return of 80% with a 95% chance of at least a positive return, and a worst-case 25% loss that only occurs in a once-in-a-century scenario? I hope so, because that has been the return dynamics for U.S. stocks, one of if not the best assets to own over the last 75 years.

Financial crises, bubbles and crashes, recessions, wars, famines, and terrorism have at times led to substantial–and painful–drawdowns, but through it all, markets still managed to provide long-term double-digit returns. Investors need only maintain emotional fortitude, think long-term, and invest with a suitable time horizon to capture ample returns.

Of the 900 potential starting months since 1945, only 6.5% would have ended with a negative five-year return. And of those starting months, all had end dates clustered around three historic events: the 1973 oil embargo, the 2000 dot-com bubble, and the 2008 Global Financial Crisis. Selling at these crisis period lows translated into 17% to 28% losses over the five-year period. Investors that held on, however, were rewarded with very good subsequent returns:

Table 1: Worst Five-Year Return Periods and Subsequent Returns

3 Worst Five-Year Periods
Source: S&P; Black Cypress Capital Management

With that in mind, I thought it worthwhile to visit the concept of proactivity. In “The 7 Habits of Highly Effective People”, Stephen Covey defines proactivity this way:

“It means more than merely taking initiative. It means that as human beings, we are responsible for our own lives. Our behavior is a function of our decisions, not our conditions. We can subordinate feelings to values…The ability to subordinate an impulse to a value is the essence of the proactive person. Reactive people are driven by feelings, by circumstances, by conditions, by their environment. Proactive people are driven by values–carefully thought about, selected and internalized values.”

Mr. Covey wasn’t talking about investing–his habits apply more broadly–but as I recently re-read the book the principles struck me as highly applicable to investing. He goes on to say, “It’s not what happens to us, but our response to what happens to us that hurts us.” That’s so true in investing.

Highly effective people are proactive. They take responsibility for their actions and they make plans before they need them. And that’s exactly what successful investors do.

The university endowment investment committee that I chair recently drafted an “adverse market plan”, where we directed the investment team to shift the asset allocation from 70% stocks to 80% stocks at the next 20% stock market decline. We created a plan, in advance, based on historical analysis and prospective thinking, designed to remove emotions and to make highly certain that good decision making occurs amid market turbulence.

What will other investors be doing the next time stock markets fall 20%? Likely second guessing their holdings and potentially selling. It is the rare individual, one who plans ahead, that has the resolve to invest additional capital when others are panicking.

The point of all this is to showcase how counterproductive it is to fret, panic, or change your investment plans due to stock market volatility. If you have the appropriate time horizon–and you shouldn’t be invested in stocks if you don’t–then the short-lived negative returns are to be kept in this context and are to be ignored entirely, or better yet, capitalized upon. And negative returns should certainly not be allowed to veer you into panic selling.

Table 2: Initial Market Decline of 20%+ and Subsequent Returns

Down 20% From ATH
Source: S&P; Black Cypress Capital Management

Since 1945, the U.S. stock market has generated positive returns over the subsequent five years that the stock market first declines 20% from an all-time-high. That is, historically, once markets are down 20%, the following five years offer solid returns. And managing risk at that point substitutes the risk of further declines for two new ones: that you’re selling at lows and that you’ll be unable (due to emotions or a lack of skill) to reenter markets before they sustainably recover. One must manage risk prior to precipitous declines.

That’s not to say there aren’t better times to invest than others. There are. By no means is this letter’s intent to build the case for mindlessly investing at all times. But I do hope it further cements the need to stay the course, and if possible, invest more, during the next bear market.

In Jacob Taylor’s novel “The Rebel Allocator”, Mr. Xavier, the hero of capitalism, notes (a rephrasing of Charlie Munger’s quote),

“It is remarkable how much long-term advantage I’ve found by trying to be consistently not stupid. You should try it sometime. Instead of aiming to be very intelligent, just don’t be a dumbass.”

So, here’s to proactivity.

In 2019, Black Cypress stocks returned 42%, net. I continue to view our forward prospects favorably, especially when compared to broad markets. We own a basket of stocks priced in such a way that I believe mid-teen returns, per year, are to be expect over the next several years.

Thank you for your continued trust,

Alan R. Hartley, CFA