If you have looked at any long-term historical returns of stocks, compared with bonds and cash equivalents, then you likely have noticed that stocks have outperformed both bonds and cash over the long term. Why, then, is it so difficult for the average investor to make money in the stock market? The attached charts provide some clues. The “histograms” chart below indicates calendar years with negative versus positive S&P/TSX Index (TR) returns. As you can see, there have been more positive histograms than negative ones, meaning there have been more “up” years (thirteen) than “down” years (six) for the S&P/TSX Index (TR) since 2000. However, within any calendar year, there is always a negative number that is associated with that particular year; and this has happened every single year, even in the “up” years!

These negative numbers are called “drawdowns,” and represent the largest annual peak-to-trough pullbacks. For example, in the year 2000, the S&P/TSX Index total return was 7%, but the drawdown for that year was 24%. There have been drawdowns every single year, and this is one of the reasons why it can be so challenging for retail investors to make money.

Let’s turn to the second chart below, depicting the S&P500 Large Cap Index, for a prime example of this effect. If you had invested in the index at the beginning of 2010, and did not look at it again until the end of the year, you would have made approximately 8%. However, if you were to look at the market every day, then you would have seen what was known as the “Flash Crash” on May 6. The markets trended down for most of the day, based on worries about the debt crisis in Greece. In the afternoon, the S&P500 Index had one of the biggest intra-day swings, of almost 9%, only to recover a large part of the loss by closing (when it was down by about 3%). There were some residual down days after May 6, and the peak-to-trough (drawdown) in 2010 was about -11%.

Many plausible theories were put forward to explain the plunge including the impact of high frequency traders, large directional bets, and technical glitches. The fact remains, short-term volatility is the nature of the stock market. As an investor, we have to focus on the fundamentals, and follow our long-term plan. These fundamentals include economic performance (e.g. unemployment rates), “risk-free” investment returns (interest rates), and investor sentiment.

Those who exited the stock market out of nervousness in the midst of the mid-2010 drawdown, likely decided to wait for the market to “calm down” before re-entering. After the dust settled, the market would have been much higher than when they sold. Eventually, the investors that had sold during the “drawdown” would realize that the train has already left the station, while they were sitting on their (smaller) pile of cash.

It is difficult for retail investors to make money in the stock market, largely due to the inevitability of drawdowns. If they repeatedly sell during the “drawdown” every year, then they will never be able to make money in the stock market, even when there are more “up” years than “down years.” This is why it is imperative to remain focused on the fundamentals, and stick to your long-term plans.