COVID-19: A Rational Reminder (EP.90)

Episode Summary

Executive Summary: In this special episode of the Rational Reminder Podcast, hosts Benjamin Felix and Cameron Passmore address the financial and emotional impact of the COVID-19 pandemic. They provide historical context on market crashes and factor investing, emphasizing that sticking to a long-term plan is crucial. The episode covers the difference between narrative and facts, the behavior of value and small-cap factors during downturns, and the importance of rebalancing and tax-loss harvesting. They stress that while this crisis feels unprecedented, markets have recovered from similar events in the past.

Main Topics: Pandemic Context and Human Response (Priority: 4/5): Discussion of the COVID-19 pandemic's impact, including work-from-home policies, social isolation, and tips for staying calm. Highlighting the importance of separating facts from narrative. Factor Investing in Downturns (Priority: 5/5): Deep dive into historical performance of value and small-cap factors during market crashes, including drawdowns and subsequent recoveries. Emphasis that factor premiums are risky and can have long periods of underperformance. Investing Through Crises (Priority: 5/5): General advice on maintaining perspective during market declines: avoid drastic changes, rebalance, tax-loss harvest, and keep a long-term view. Reference to historical crashes and recoveries. Historical Data on Market Crises (Priority: 5/5): Presentation of data from papers covering 1,032 market crashes (50%+ declines) across 101 global markets from 1692 to 2015, showing that markets tend to rebound after large drops. Also discusses 1918 and 1957 pandemics. Rebalancing and Tax-Loss Harvesting (Priority: 4/5): Practical planning tips: selling losing positions in non-registered accounts to realize losses, buying non-identical securities, and the importance of rebalancing portfolios after significant market moves.

Key Arguments: Sticking to a long-term plan made in calmer times is critical during market stress. Factor tilts (value, small-cap) can experience severe drawdowns but historically have delivered large premiums after crashes. The narrative surrounding a crisis is always different, but the empirical data shows markets have recovered from all 1,032 historical crashes of 50% or more. Attempting to time factor premiums using value spreads is deceptively hard and can reduce diversification. Tax-loss harvesting is not free due to potential tracking error; it's best used when there are offsetting gains.

Data Points: U.S. market max drawdown 1929-1932: 83.7% - Peak to trough drawdown during the Great Depression. U.S. value max drawdown same period: 87.5% - Deeper drawdown than the market for value stocks. U.S. small-value max drawdown same period: 88.7% - Almost 90% decline for small-cap value. One-year value premium June 1933: 177% - Premium relative to the market; absolute value return was 334%. One-year small-value premium June 1933: 234% - Premium relative to the market; absolute small-value return was 392%. Market return same period: 157.5% - Absolute return for the U.S. market from July 1932 to June 1933. Number of historical crashes (50%+ decline): 1,032 - Across 101 global stock markets from 1692 to 2015. Worst decade negative value premium (recent): -3.15% annualized - Ended July 2016, similar to the 1939 period. Worst decade negative value premium (1939): -3% annualized - Ended December 1939. Value premium decade ending December 1945: 5.48% annualized - After negative period, value beat the market by 5.48% per year. Small-value premium decade ending December 1945: 11.28% annualized - Significant outperformance after a negative decade. S&P 500 inclusion of top 10 months impact: 10.08% vs 7.74% annualized - Removing the 10 best months (0.9% of months) drops the return from 10.08% to 7.74%. MSCI ACWI return Jan 2000 to Feb 2020: 6.56% annualized - In Canadian dollars, through multiple crises. S&P 500 return 1871 to 1930: 5.01% annualized - Through many panics and crises.

Pivotal Quotes: "We believe that sticking with the process is the only way to achieve the long-term gains we seek. We also know that sticking with something that's good through its occasional, very bad times, and even acting as a contrarian when others are finding newly created reasons to throw in the towel is very difficult. But this very Difficulty is a large part of why we believe it's long-term rewarded." — Cliff Asness (quoted by Benjamin Felix): On persisting with value investing despite painful performance. "If something were easy, everyone would do it." — Cliff Asness (quoted by Benjamin Felix): Explaining why factor premiums persist despite being well-known. "Your return is a combination of your expected return and your unexpected return. And the unexpected return you can't control. The expected return you can control." — Unnamed expert guest (quoted by Benjamin Felix): Emphasizing the importance of focusing on the decision process, not outcomes.

Implications: Listeners should understand that market crises are normal and recoveries follow. Do not abandon a well-thought-out plan. Use downturns to rebalance, tax-loss harvest, and learn about your own risk tolerance. Factor investors must expect long periods of underperformance; discipline is essential to capture long-term premiums.