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Investing can be absolutely brutal. In fact, I can say with a high degree of confidence that the “current” investing environment is by far and away the most challenging that I’ve experienced. However, that was also true during the lows of the GFC, during the European Sovereign Debt crises, the (original) Taper Tantrum, Brexit, Fed induced euphoric markets, Covid and numerous Geopolitical conflicts. A new record each time.

If we could invest with 20:20 hindsight, then our job would be so much simpler, but it just doesn’t exist. Much of investing is about extrapolating into the future and envisioning how we expect a business to look 5 or 10 years from now. There is inherent uncertainty – there’s no such thing as a free lunch. To earn a return, you must be willing to accept some form of risk. Usually, the more risk you are willing to take, the higher the possible return. However, the flipside of that coin is that it also increases the chance that your investment will lose money. Often, the riskier it is, the more you stand to lose.

Ultimately, the goal is to protect your downside.

In this post, I will look at some lessons that the market is urging us to learn from the current investing environment. I am always cautious about drawing conclusions from graphs, since often, by changing the timeframe and selecting a different start/end time point, one can be led to draw completely different conclusions.

By “picking” particular asset classes/sectors, I will demonstrate the best lessons I believe need to be learnt from the current environment. These lessons are timeless. They were just as true 10, 20, or 50 years ago as they are today, though they have (probably) moved to different sectors/asset classes as the years passed. Investing is tainted by behavioral biases (at least in the short term), meaning that all the theory in the world, on its own, cannot adequately prepare you for real life experience in the market.

Note, in this post, I am specifically focusing on past performance and not making any sort of projections into the future or looking at current valuations. By looking at the past as a guide we will understand timeless lessons of the market.

Here are a few lessons that I feel the current market wants us to pay attention to:

1) Understand that equities are the most risky part of the capital structure. Whilst they are typically the most lucrative, that comes with a price attached – volatility.

Equities allow one to earn a share of the profits of large global companies. In a way, investing is a “bet” on the ongoing creative spirit of mankind. Over the long term, equities tend to earn you an annualized 8%-10%. (Indeed they have grown at 9.97% annually since 1985). However, that comes with the price of volatility, and drawdowns are to be expected. Using the S&P 500 as “the market”, we can see (courtesy of PortfolioVizualizer.com) that since 1985, $10,000 invested in 1985 would have grown into more than $160,000 today, at an annualized growth rate of 9.97%).

The portfolio (on a monthly basis – it would have been substantially more on a daily basis), would have endured a 45% drawdown during the Technology bubble, a further 50% during the Global Financial Crisis, and a rapid 35% decline at the beginning of COVID-19.

Indeed, over the past 3 years (2019 -2021), the market compounded at an insane 26% annualized return.

That rate of return is not sustainable. In order to obtain the “typical” 8%-10% returns, one has to accept the price of volatility and market drawdowns. That doesn’t make drawdowns any easier to bear. Nonetheless, acknowledging that they are a natural part of the stock market is a healthy first step. In other words, by accepting an 8%-10% long term annualized return and at the same time understanding that the last few years have compounded at unsustainable levels, one is expecting a drawdown to occur, in order to bring market returns back in line with historic norms. This, my friend, is that expected drawdown.

2) Given that an 8%-10% gain in the stock market is considered “average”, an “average” year is not the norm, and occurs far less frequently than an abnormal year!

3) Internalize that investing in the stock market requires a sufficiently long time horizon.

Investing in the stock market at any point in time is nothing more than a best guestimate over the short term as to whether your investment will be up or down 1 year later. Much of investment gains and losses can be attributed to investor emotions over the short term. The price that one is willing to pay for a share of corporate profitability in the future fluctuates heavily depending upon emotions.

Indeed, data from the last 50 years of investing in US stock market show us that possible ranges of performance 1 year later span from negative 43% to positive 67%.

The longer one’s time horizon, the higher the chance of success, and the lower the probability of negative returns. Indeed, there has not been any rolling 12-year period where there was a negative return.

Particularly, as one goes through periods of negative drawdowns, and mark to market volatility, it is imperative that one takes this evidence to heart and remembers that as long as our timeline is long enough, the evidence is overwhelmingly in our favour, market drawdown and all.

4) When an asset (class) is priced for perfection and has reached extreme levels, don’t assume that will prevail forever.

Here is a graph of the Fed funds rate going back to the early 1950s. With yields reaching a mere 5 basis points (0.05%), the lemon has been well and truly squeezed. Never say never in the investing world, but if the US would have negative nominal rates, then the world would be in a very bad place indeed. Surely, it can “never happen”! Nonetheless, there is minimal justification in trying to squeeze the lemon any further.

The Fed has arguably been behind the curve for a very long time, and with inflation hitting levels that have not been seen for many years, the Fed has done a full 180 and is doing its utmost to raise rates (or getting the market to do it for them) whilst they are still able. At the same time, as growth slows, the consumer is getting squeezed by inflation, a global energy crisis, mortgage rates already higher than they have been in the last 20 years, and the onset of Quantitative tightening. That little blip in the rise of the Fed funds rate in the bottom right hand corner last month (to a massive 0.33%), together with all the nervousness of the last few months around inflation, have been enough for bonds to have been absolutely decimated in the last few months, as yields (particularly at the short end of the curve) have risen dramatically.

The losses on “boring/stable” US Government bonds have been monumental:

Intermediate Term Government Bonds 7-10 years (ETF ticker IEF): drawdown of almost 12%

Long Term Government Bonds 20 years+ (ETF ticker TLT): has lost almost a quarter of its value this year and is down 23%.

Note, that the negative performance has not come about because of a widening of spreads due to fear about US Corporations – this is evidenced by Investment Grade Bonds and High Yield Bonds both being in a far shallower drawdown at 16% and 10%, respectively). The drawdown has stemmed from rising yields which has had a far larger impact on Government Bonds. In fact, Government Bonds have gone from having diversification benefits on an overall multi-asset portfolio to being an additional source of risk!

5) Make sure you understand what you are investing in.

There have been many calls to protect the “real value” of your portfolio and not have inflation eat into your returns. TIPS, otherwise known as Treasury Inflation Protected Securities, is one area that has been endorsed by many investment advisors. An abundance of money, particularly of late, has poured into this space as investors look to protect themselves against rising inflation.

TIPS in a nutshell are Government Bonds whose coupon (and principal) is readjusted to take into effect inflation. Something not commonly understood, though, is that:

1) TIPS offer protection over and above “expected” inflation. If the market is expecting inflation of 5%, and ultimately inflation comes in at 3%, then your TIPS are likely to lose value. There was indeed inflation, but it was not as high as the market was expecting and had already priced in.

2) TIPS in essence are a bond, a Fixed Income instrument that will lose value and draw down in a rising rate environment.

For example, someone purchasing a TIP ETF at the beginning of 2018 expecting inflation to kick in, would have earned a 4% annual return. However, once inflation is factored into the equation, that return would be a meagre 0.4% annualized, and they would be in the midst of a 5.2% drawdown even as inflation comes in north of 7%.

6) Investing (and stock picking in particular) is hard!

If we cast our mind back to the Corona period when the market was led by a number of stocks that were priced for everlasting perfection plus change! Peloton (PTON) at one point was up almost 500% from its pre-Corona prices. Shopify (SHOP) was up over 200%. PayPal (PYPL), a mere 125% with Facebook (FB) and Netflix (NFLX) not far behind. Unbelievably, if one would have invested in the market (S&P 500) at the onset of corona, and then held on ever since, one would have made more money than by investing in any of these (former) darlings of the market.

I’m sure there were many reasons/theories as to why these stocks went up so much, and why they subsequently crashed. But for me, the key takeaway is that investing is hard! Individual stock picking can make you look both a genius and a fool.

I can understand the lures of stock picking, but realize that the only reason why there are such mammoth gains to be made, is precisely because there may well be mammoth losses too. And even professional money managers are not immune to getting drawn up into potential hype and “justifying” why a certain valuation may make sense for whatever reason. I personally prefer sector/regional investments via passive ETFs. You may not pick up as much upside as with an individual stock pick, however, you are naturally diversified and far more protected in the event of downside risk. Obviously ETFs are also prone to volatility and in significant bouts too. But even so, they avoid the inherently riskier individual stock picks.

Individual stock picking is fine, but make sure you understand the additional risks that you are exposing yourself to. They are likely to manifest in the form of increased volatility and severe mark to market drawdowns. Make sure that you always invest in instruments that are appropriate for the timeframe for which you anticipate investing. It is also important to be aware of how much potential drawdown you are likely to experience in a worst case scenario and to be comfortable with that level of risk.

7) All this leads me to ……… Diversification!

Diversification is one of the most beneficial investment strategies as I have outlined in the link above. Please take a look to refresh your knowledge on the topic so that you can make optimal investing decisions even in these rocky stretches of time.

My goal in writing all of this is to help you get your feet back on the ground even as the situation seems to be spiraling in the wrong direction. We have much to learn from previous market patterns, and I hope that the data I have presented has enriched your understanding of the markets.

What’s another rule that needs to be repeated when the markets are down?

I’d be happy to hear your advice.

Original Post

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.