Market Decline Shakes Investor Confidence
The overview of last quarter appears docile enough at a glance: overall market down 1.9%, Upgrading down 3.7%. Ho hum. But the overview fails to relate the depth of emotion most investors felt during the 2nd quarter's wild ride.
The quarter started well enough, with the first six weeks continuing the strong surge that had the broad market indexes up 6-7% by early May, and Upgraders up more than double that at roughly 16%. But as inflation data continued to come in stronger than expected, investors reconsidered the future path of interest rates and the economy.
A consensus began to emerge that an economic slowdown was likely later in the year, and the stock market changed direction. Over the next month, the market indexes dropped roughly 8%, but investors with more foreign and small-company stock exposure suffered even more. As is often the case in market downturns, the funds that had been up the most also fell the furthest. SMI Upgraders saw much of their 2006 gains evaporate during a gut-wrenching five weeks (although they rebounded a bit during the final weeks of the quarter). After being lulled by three years of unusually low market volatility, the sharp decline provided a vivid reminder that the stock market can—and does—move quickly in either direction.
Both of SMI's model portfolios trailed the market last quarter. But despite the recent bumps in the road, their long-term track records remain strong. As the "100% Stocks" section of the table below illustrates, our simple Just-the-Basics indexing strategy continues to roughly track the market, as intended. And Upgrading continues to excel, whether looking only at 2006 year-to-date returns, or looking further back into the past. Note the bottom lines of the table which show the overall market up less than a third (+22.0%) of what Upgrading has returned (+77.0%) over the past five years.
Upgrading and the May-June Market Correction explored in some detail the factors influencing Upgrading's performance during the May-June market decline. We encourage you to read that discussion, as it explains why there will inevitably be periods when Upgrading lags the overall market. But over time periods measured in years, the diversification and discipline of Upgrading has dramatically boosted returns without significantly boosting volatility. But in the short-term, measured in weeks or months, it's not unusual to see Upgrading's performance vary significantly from the overall market.
Unfortunately, volatility like we experienced last quarter isn't particularly unusual. The stock market experiences a correction of 10% or more roughly once per year, on average. The recent stretch of roughly three years without one is one of the longest on record. The stock market's inherent short-term volatility is why we consistently admonish readers to only invest money in stocks if they can afford to leave it there at least five years. Stock investing generally, and Upgrading specifically, require time and patience to be successful. Thankfully, the long-term track records of both offer plenty of reason for confidence. 
- SMI's Investing Principles page
- Performance History
- How to Take Market Turbulence in Stride
- How to Make Rational Investing Decisions
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