Note: watch a video of this post here.
When investors think about risk, it’s the extremes that immediately come to mind…
- 1929 (Great Depression)
- 1987 (Black Monday Crash)
- 2000 (Dot-Com Bubble)
- 2008 (Financial Crisis)
- 2020 (Pandemic Crash)
The commonality: fear, panic, and catastrophic losses.
While these periods are all front and center in our minds, the reality is that risk is always present, even if you can’t always see it.
From the March 2009 low through the high earlier this year, the S&P 500 gained 818%. That’s an annualized return of nearly 19%.
This is what a chart of that incredible growth looks like over time…
Looks like an easy ride, but any investor living through the last 13 years will tell you otherwise.
There have been 27 corrections since the March 2009 low of more than 5%. Of these, 9 were larger than 10%, 3 exceeded 20%, and 1 was more than 30%.
Before investing, many will tell you that they can stomach a 20% decline – they can “tolerate” such a risk.
But when it actually happens, and real dollars are at stake, the true test begins.
This is what a 20% decline looks like in real time…
Not pretty. And not easy to sit through while many were prophesizing that the losses would continue.
These were a few of the headlines on the day of the low in 2011…
Notice the fear-inducing language…
“worst quarter since the 2008 financial crisis, and the swoon is hardly over”
“eerily reminiscent of the months leading up to the Lehman Brothers’ bankruptcy in 2008”
If you held your position through 2011, you would be tested again seven years later. In 2018, we saw a similar decline over a shorter period of time.
Once again, the headlines were not good…
“worst week since Great Recession“
“The last time the market fell this much in December was 1931, during the Great Depression”
If you held on through 2018, the biggest test since the financial crisis would come in early 2020.
The pandemic crash would take stocks down 35% in a little over a month, the fastest bear market in history.
On the day of the low (March 23), the outlook was bleak…
“many fear the worst has yet to come” with experts predicting the “biggest economic downturn since the Great Depression.”
All news was bad news at the time, wreaking havoc on investor psychology…
It’s tempting to believe you could’ve sidestepped these losses, receiving all of the upside with none of the downside. But no one has shown an ability to do so in a repeatable fashion.
Which means that large declines and the fear-inducing narratives associated with them are the price of admission for long-term investors.
What does that mean?
In simplest terms: risk is the price you pay for the possibility of higher long-term reward.
Let me explain…
Since 1928, the S&P 500 has generated an annualized total return of roughly 10% versus 5% for Bonds (10-Year Treasury) and 3% for Cash (3-Month Treasury Bills).
Why have equities returned a premium over bonds and cash?
There are many different theories, but these are the strongest arguments…
- Economic uncertainty: the value of future cash flows on stocks is uncertain due to fluctuations in the overall economy.
- Long-run growth risk: small downward revisions in long-term growth can translate into significant changes in stock prices.
- Myopic loss aversion: investors are more sensitive to losses in wealth than gains and take a short-term (myopic) view of their portfolio.
The common theme? Risk. Uncertainty. Potential for loss.
Which is another way of saying that there’s no free lunch. The premium you earn from owning equities over bonds/cash is primarily due to the higher volatility and drawdowns you must stomach over time.
We observe this each and every year in the equity market, to varying degrees. In the median year since 1928, an investor in the S&P 500 has experienced a 13% drawdown at some point during the year.
Another way of looking at this is to view the historical odds of varying intra-year drawdowns. We have seen a decline of at least 10% every other year, and a 20% decline every 4 years on average.
Risk, of course, is not limited to a single year, but can be extended over multiple years in a longer bear market. This is to be expected if you are an equity investor, with a 30% decline occurring roughly once every 8 years and a 50% decline every 20 years.
These are historical averages and the future will not look exactly like the past. But the overarching point is clear: if you’re a long-term investor in equities, experiencing a large decline is a matter of when, not if.
And when these declines come, I can assure you that you won’t be thinking in terms of percentages.
Which is why when trying to assess someone’s actual risk tolerance (no easy task), you should always convert to dollars. A 50% decline for someone with $10,000 invested early in their career is not going to be viewed nearly the same as a retiree that has $1 million invested. A $5,000 drawdown is more tolerable than $500,000 to almost everyone, even though the percentages are exactly the same.
As I’m writing this, the S&P 500 is in the midst of a 12% drawdown.
How long will it continue?
The low might already be in, it could extend into a 20% decline, or it could turn into something much worse.
And that’s ok, as long as you’re prepared for it. For uncertainty is a feature of equity markets, not a bug.
Bearing that risk is the price of admission for long-term investors in stocks, without which there would be no reward.
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.” – Peter Lynch
To sign up for our free newsletter, click here.
Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.