Overview: An IPS can provide clients with the discipline needed to stick to their strategy. It can also help reduce the risk of emotions (greed and envy in bull markets and fear and panic in bear markets) affecting the decision-making process.
 

From September 1929 through June 1932, the S&P 90 Index fell 83.4 percent. In comparison, the 41.8 percent drop the S&P 500 Index experienced from September 2008 through February 2009 seems like a walk in the park. The severity of the new bear market has tested the patience of even the most disciplined of investors, as it has been even worse than the two other severe bear markets we have experienced during the post-war period. The S&P 500 fell 37.2 percent from January 1973 through December 1974 and fell 40.2 percent from January 2000 through February 2003.

 

It seems worthwhile to examine how investors who had the discipline to stay the course fared after June 1932. This would at least provide some perspective for today’s investors. Before looking at the data, keep in mind that the Great Depression still had years to run before World War II brought it to an end. The following are the returns for the one-, three-, five-, 10- and 20-year periods beginning in July 1932.

 

Returns Since July 1932
	Annualized Return (%)	Total Return (%)
One Year	162.9	162.9
Three Years	39.3	170.5
Five Years	34.8	344.8
10 Years	12.5	225.9
20 Years	15.4	1653.0

 

The returns for all of the periods are well above the index’s long-term return of slightly less than 10 percent. Just when things seemed gloomiest, disciplined investors were well rewarded for their patience. However, those returns were not earned easily. Along the way investor discipline was sorely tested. Consider these total return figures:

 

Various Returns Following Market’s Greatest Drop
	Total Return (%)
September 1933–October 1933	–18.8
February 1934–July 1934	–20.7
March 1937–March 1938	–50.4
January 1939–May 1940	–24.1
September 1941–April 1942	–22.4
June 1946–April 1947	–21.0

 

These kinds of losses certainly would have tested the discipline of even the most patient investors. In fact, these kinds of losses explain why the equity risk premium has been so high — equities are risky investments no matter how long the horizon. That must be so, or there would be no risk premium! Thus, the lesson for investors is that while there is certainly no guarantee that equities will provide the kind of returns investors have come to expect (roughly 10 percent), the historical record demonstrates that the best returns have generally occurred right after severe bear markets.

 

In addition to the data shown above, consider the following. After the bear market of 1973–74, the next five years saw the S&P 500 provide investors with a return of almost 15 percent per year, or more than 50 percent above the long-term average. And after the bear market of 2000–02, the next five years provided investors with a return of almost 13 percent per year, or more than 30 percent above the long-term return.

 

Discipline is the key to successful investing. A formal investment plan in the form of an investment policy statement helps provide the necessary discipline. Support for IPSs comes from Meir Statman, a behavioral finance professor at Santa Clara University. “Our psyches hold the key to much of our investment behavior.”

 

He likens the situation to antilock brakes. “When at high speed, the car in front of us stops quickly, we instinctively hit the brake pedal hard and lock ’em up. It doesn’t matter that all the studies show that when the brakes lock, we lose control.” Statman suggests that investors need antilock brakes for their investment portfolios as well. 
 

An IPS can act as an investor’s antilock braking system and help provide the discipline to stick with the plan. It can also help reduce the risk of emotions (greed and envy in bull markets and fear and panic in bear markets) affecting the decision-making process.