Staying the Course – Lessons from 2020

2020 was a year investors will not soon forget. A pandemic, a recession, the end of a more than decade-long bull market (and the beginning of another bull market), all-time highs for the VIX, lockdowns, the prices of oil futures turning negative, a tense U.S. presidential election cycle, unemployment spiking more than 10 percentage points in a matter of months—the list could go on for some time. And after all of it, an above-average calendar year return for U.S. stocks.

Figure 1 in this PDF plots the cumulative return of the S&P 500^® Index throughout 2020, along with some corresponding news headlines. The index finished the year up more than 18%, but as you can see in the chart, it wasn’t a smooth ride. After hitting all-time highs in February, stock prices plunged as the seriousness of COVID-19 became more apparent and fear levels skyrocketed about its impact on the economy. Volatility levels spiked amid the downturn, and data from the Investment Company Institute shows many investors flew to government money market funds. See the bottom section of Figure 1 that plots weekly government money market fund flows.

While these flows likely provide an indication about investors’ current appetite for risk, they can also help illustrate the potential opportunity cost of trying to time markets. We conducted an experiment that looked at aggregate inflows and outflows from money market funds and subsequent equity returns to demonstrate the significance of this opportunity cost. Figure 2 summarizes the results. 

Figure 2 | Money Market Flows: What Would They Be Worth If They Had Been Invested in the Market?

Source: Avantis Investors. Money market flow data from the Investment Company Institute. Index Returns from Bloomberg. For index returns over longer time periods, please see disclosures.

First, we summed all the weeks where government money market funds had net inflows and all the weeks where they had net outflows. Weeks with net inflows amounted to almost $1.5 trillion, while weeks with net outflows totaled $531 billion. To put the influence of the flight to safety seen earlier this year on these totals in context, between the weeks ending February 19 and March 25, around $750 billion moved into government money market funds, emphasizing the level of anxiety some investors were facing due to the market downturn. If we extend that period to the end of April, when the market had already begun to recover but a high level of uncertainty remained, the inflows into government market funds reached $1.2 trillion.

Unfortunately, all these assets that sought safety in short-term government instruments didn’t enjoy the full market recovery. When we compute the opportunity cost of not being invested in the S&P 500 Index for the net inflow weeks into money market funds, we see the $1.46 trillion that went into these stable investments could have become more than $2 trillion if left in the market, or the equivalent of an average return of 41.49%. This is substantially higher than the 18.40% total return for the S&P 500 Index for the year, meaning dollars were on the sidelines during the more rewarding parts of the year.

There were some weeks when government money market funds saw net outflows. If we use the same methodology as above and assume these flows were directed to the S&P 500 Index, the average return for those outflows would have been 14.22%. This is lower than the 18.40% total return for the S&P 500 Index, meaning the average dollar would once again have been better off in the market throughout the year.  

The astonishing asymmetry of the returns reiterates the ill timing of the cashflows. There is a critical lesson in setting and managing expectations about what can happen in the stock market. Constructing an asset allocation that reflects our risk tolerance and is realistic about the possibility of market downturns of the magnitude we saw in February-March 2020 can help investors avoid selling in times of panic, when prices are depressed not only by news but also by collective selling that can add liquidity concerns to an already high level of uncertainty. 

GLOSSARY

VIX - Volatility indexes are forward-looking measures of the market's expectations of volatility (or how much a stock index's price moves). The CBOE manages and publishes three of the most widely used volatility indexes based on three major stock indexes: The VIX Index tracks the expected 30-day future volatility of the S&P 500 Index, the VXN Index tracks the expected 30-day future volatility of the NASDAQ-100 Index and the VXD Index tracks the expected 30-day future volatility of the Dow Jones Industrial Average Index. VIX, VXN and VXD are the ticker symbols for these three volatility indexes. The VIX in particular is a widely used measure of market risk and is often referred to as the "investor fear gauge."

S&P 500^® Index - The S&P 500^® Index is composed of 500 selected common stocks most of which are listed on the New York Stock Exchange. It is not an investment product available for purchase.

MSCI World ex USA - Captures small cap representation across developed markets countries (excluding the United States), covering approximately 14% of the free float-adjusted market capitalization in each country.

MSCI Emerging Markets - A free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.

Bloomberg Barclays U.S. Aggregate Bond Index - Represents securities that are taxable, registered with the Securities and Exchange Commission, and U.S. dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Bloomberg Barclays Global Aggregate Bond Index - A broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.

Bloomberg Barclays U.S. 1-3 Month Treasury Bill Index - A sub index of the Bloomberg Barclays U.S. Short Treasury Index, the Bloomberg Barclays U.S. 1-3 Month Treasury Bill Index is composed of zero-coupon Treasury bills with a maturity between 1 and 3 months. As Treasury bonds and notes fall below one year-to-maturity and exit the Bloomberg Barclays U.S. Treasury Index, they become eligible for the Bloomberg Barclays U.S. Short Treasury Index. It excludes zero coupon strips.