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

Episode Summary

Executive Summary: A special Rational Reminder episode addressing COVID-19 combines public-health context, market history, factor-investing evidence, and practical portfolio guidance. The hosts argue that crises are emotionally different but historically familiar: markets recover, factor premiums can be painful before rewarding, and investors should avoid reactionary allocation changes. The episode emphasizes staying invested, rebalancing, and using volatility for tax-loss harvesting rather than market timing.

Main Topics: COVID-19 as a public-health crisis and information challenge: The hosts discuss the pandemic’s health risks, asymptomatic spread, and how rapid information sharing and expert podcasts have helped them understand the situation. They stress social isolation and preparation as essential responses. Working from home and client communication during the shutdown: They explain how their firm quickly shifted to remote work with Teams, Zoom, and Fellow, highlighting operational resilience and that clients are mostly concerned about health rather than portfolios. Historical evidence on factor investing in crashes: Ben presents data showing that value and small-cap value often underperform before and during crises, then can rebound sharply afterward, illustrating why factor investing is hard to stick with. Why narratives matter less than empirical history: The hosts contrast scary contemporary narratives with long-run historical data on pandemics, recessions, and market crashes, arguing that stories change but market recovery has been remarkably common. Investing through crises: stay the course: They recommend avoiding drastic changes, maintaining long-term perspective, rebalancing as needed, and remembering that uncertainty is normal in equity investing. Planning actions: tax-loss harvesting and rebalancing: The planning section covers when tax-loss harvesting can make sense in Canada, the importance of avoiding superficial loss rules, and why rebalancing is especially important after large market moves.

Key Arguments: Crisis should not be used as a reason to change long-term asset allocation; instead it may reveal your true risk tolerance and inform future planning. Factor strategies like value and small-cap value can experience prolonged underperformance and deeper drawdowns, but history suggests their premiums can arrive later in a very large way. The current episode’s most relevant comparison is not only financial crises but also past pandemics, especially the 1918 and 1957 influenza outbreaks. Markets are pricing uncertainty, not irrationality; sharp moves can reflect rapidly changing expectations for earnings and risk. Narratives are powerful but often misleading; investors should separate stories from facts and rely on long-run empirical evidence. After major market declines, large positive returns have historically been more likely, making panic selling after a crash especially risky. Tax-loss harvesting can be valuable in taxable accounts, but it is not free because it can introduce tracking error and reduce portfolio simplicity. Rebalancing is a core investment discipline and becomes more important when markets move quickly and portfolios drift from target weights.

Data Points: Date recorded: Sunday, March 15, 2020 - The episode was recorded during the early COVID-19 market turmoil. DFA global equity portfolio year-to-date return: -22% - Used as an example of drawdown in an all-equity factor-tilted portfolio as of Friday, March 13. Vanguard all-equity ETF year-to-date return: -16% - Compared to the DFA portfolio to illustrate tracking error and factor/currency effects. Estimated tracking error versus VEQT: ~6% - Roughly split between small-cap/value exposure and DFA’s partial currency hedge. Value premium trailing market (3 years to Sept. 1929): -4.1% per year - Shows value had been underperforming before the Great Depression crash. Small value premium trailing market (3 years to Sept. 1929): -9.63% per year - Shows even larger pre-crash underperformance for small-cap value. Value premium in Oct. 1929: +8% - A one-month positive relative return during the crash period. U.S. market max drawdown in 1929-1932: -83.7% - Peak-to-trough decline from Sept. 1929 to June 1932. U.S. value max drawdown in 1929-1932: -87.5% - Value fell more than the broad market in the Great Depression drawdown. U.S. small value max drawdown in 1929-1932: -88.7% - Illustrates how severe factor drawdowns can be in crises. One-year value premium in June 1933: +177% - Relative premium over the prior 12 months after the crash bottom. One-year small value premium in June 1933: +234% - Shows enormous rebound in small-cap value after the Depression-era low. U.S. market return over that same 12-month period: +157.5% - Absolute market return from July 1932 to June 1933. Value absolute return over that 12-month period: +334% - Highlights the scale of post-crash rebound for value stocks. Small value absolute return over that 12-month period: +392% - Highlights the scale of post-crash rebound for small-cap value stocks. Worst trailing 10-year value premium ending Dec. 1939: -3% annualized - A historical example of a prolonged negative factor premium window. Worst trailing 10-year small value premium ending Dec. 1939: +2.03% - Small value did better than value in that overlapping period. Value 10-year premium ending Dec. 1945: +5.48% annualized - Shows how quickly the trailing decade can flip from bad to very good. Small value 10-year premium ending Dec. 1945: +11.28% annualized - Large positive long-horizon premium after the earlier period of pain. Value 10-year premium ending Feb. 2000: -1.76% annualized - Illustrates the late-1990s growth boom and value underperformance. Value 10-year premium ending Feb. 2001: +4.92% annualized - One year later the trailing decade flipped positive. Small value 10-year premium ending Feb. 2001: +6.05% annualized - Likewise turned positive after the tech bubble peak. Worst recent trailing 10-year value premium ending July 2016: -3.15% annualized - Used to show recent underperformance is historically plausible. Worst recent trailing 10-year small value premium ending July 2016: -1.56% annualized - Small value also suffered over that decade. 1957 Asian flu economic impact in Canada: -1.2% industrial production at peak - Historical example of a pandemic with measurable but temporary economic disruption. 1957 Asian flu economic impact in the U.S.: -1% GDP - Shows recovery after the pandemic tapered off was almost immediate. U.S. market max drawdown during 1957 episode: ~15% - Post-outbreak market decline cited as a comparison point. U.S. value max drawdown during 1957 episode: 23% - Factor portfolios again showed larger declines than the broad market. U.S. small value max drawdown during 1957 episode: 21% - Another example of larger factor drawdown. Annualized U.S. market return from Feb. 1957 to Dec. 1958: 16.93% - Shows positive recovery over the full pandemic period. Global stock markets studied in Negative Bubbles paper: 101 markets - Long-run dataset covering 1692-2015. Crashes analyzed in that paper: 1,032 events - Defined as market declines of more than 50% over 12 months. S&P 500 annualized return 1926 to Feb. 2020: 10.08% - Baseline comparison for the effect of missing top months. S&P 500 annualized return excluding top 10 months: 7.74% - Shows how a tiny number of great months drives long-term returns. ACWI return in CAD terms, Jan. 2000 to Feb. 2020: 6.56% annualized - Used to show markets survived multiple shocks this century. S&P 500 return 1871 to 1930: 5.01% annualized - Illustrates resilience despite many historical panics.

Pivotal Quotes: "A crisis is not a reason to change your asset allocation" — Benjamin Felix: Explaining that market stress can reveal risk tolerance, but should not trigger reactive strategic shifts. "If we look back on this in a year or six months or 10 years or whatever, if we look back in this period of time and think, wow, we really overreacted, that's one of the best outcomes that we could have." — Benjamin Felix: On the right way to judge society’s response to the pandemic. "Your return is a combination of your expected return and your unexpected return, and the unexpected return you can't control." — Benjamin Felix: On why behavior during uncertainty can matter more than the nominal investment thesis.

Implications: Listeners should expect volatility, avoid panic-driven strategy changes, and use the crisis to test risk tolerance. Long-term investors should rebalance, consider tax-loss harvesting carefully, and trust that markets and economies have historically recovered from severe shocks.