A closer look at market performance

When asking investors for their goal, I often hear them say they’d like to “beat the market”. This goal dates back to 1973, when Princeton professor Burton Malkiel claimed that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts”, see his book A Random Walk Down Wall Street. So “beating the market” is really about “beating the monkey”, as probably we would all like to do at least a little better than that poor trading monkey.

Let’s take a closer look at how exactly the market performed in the past. As a reference for market performance, I will use the performance of SPY, an ETF designed to closely track the performance of S&P 500.

The simplest way to do so, is to compare the raw numbers over the past 10 years:

SPY closing prices (unadjusted)
12/29/2006: 141.62
12/30/2016: 223.53
timespan:    10.0 years
CAGR:         4.67%

Given today’s risk-free rate of return (90 day T-Bill rate, as of September 2017) of about 1.04% x 365/91 = 4.17%, this really isn’t too exciting. Admitted, I have been ignoring the dividends here, but even with dividends, the situation doesn’t improve too much. Much more important is the fact that performance was everything but smooth over these years, as this plot shows:

The green plot shows, that overall the market indeed climbed by about 58%. The red area shows the so-called drawdown, which is the loss relative to the previous highest-high. In March 2009, our drawdown peaks at -56%, relative to the previous highest-high in October 2007. Even worse, it took full 5 years- all the way until March 2013- to recover from this massive drawdown!

One way to look at the recession in 2008 is, to consider it a once-in-a-lifetime event. In doing so, we could ignore the huge drawdown, and evaluate performance without it:

SPY closing prices (unadjusted)
03/05/2009:  68.80
12/30/2009: 223.53
timespan:     7.82 years (1971 trading days)
CAGR:        16.26%

That looks much better! Going back to the plots, we find that the green performance curve will just be cropped on it’s left side. The red drawdown area will change it’s shape though:

What we see is, that even after eliminating the 2008 event, we still face frequent drawdowns of 5% or more, and some peaks in excess of 15%. While I personally don’t believe that we can simply ignore 2008, this exercise helps to understand what the ‘normal’ volatility of the market is like, and how much performance we can expect under those conditions.

We have gained a good understanding of the drawdowns now, but the performance is still a bit fuzzy. Performance becomes easier to grasp, when looking at it in yearly intervals:

We see the dramatic loss in 2008, and we can see how 2011 and 2015 have been flat. However, this binning hides a lot of relevant information. It is therefore beneficial, to plot the 12-month performance over a sliding window instead:

This gives us a much more detailed view of our performance, revealing many more periods of concern, and showing that even in non-turbulent times, market performance remains a risky proposition.

With all of this in mind, it seems that beating the market is not nearly enough, if an investor wants to sleep well at night. Seeing how long it takes to recover from deep drawdowns, it is much more important not to lose money in the first place. Also, the the current hype of index-funds might not be justified.