How Much Loss Can You Handle?

As the stock market continues its seemingly unstoppable rise, many have forgotten that it doesn’t always go up.  Other than the Great Depression, I can’t recall a generation that has endured so much market volatility – but memories are short these days.

We’ve experienced two U.S. stock market drops of at least 50% in just the past 13 years and John Bogle the other day predicted two more in the coming decade.  Using the Shiller CAPE measurement to value stocks, they appear quite overvalued.  At a minimum they are not cheap, yet each and every day the market moves higher.  There has not been a three day losing streak in 2013.

Many investors are asking themselves why they are not in the market, not in the market with more of their assets or if they should borrow to put money into this market (I kid you not, I get these calls).  Instead of getting into valuation measurements, mean reversion and profits in relations to GDP, I thought I’d just provide a simple chart showing how much a person would have lost from the top of a market to the bottom of a market with different stock exposures during the past two market downturns, 2000 and 2007.

I’ve added a label to each portfolio of Conservative, Moderate and Aggressive to give you an idea of what the industry would consider each portfolio in terms of its risk profile.

Potential Stock Losses

The “months” at the bottom indicate how many months between the top and the bottom, in other words, how long did it take for the market to go from peak to trough.

In the 2000 – 2002 (forgive the error in date in the chart) the market fell a little over 50% from its high before beginning its recovery.  Ironically, the market hit a new peak almost exactly five years later and then fell over a 15 month period a total of 56%.

Even a conservative investor lost up to 17% during these two drawdowns.

I used the Vanguard Total Stock Market Index as my proxy and assumed it was paired with a stable value type fund that earned 0%.  Neither assumption is perfect as some held fixed income that went up during these stretches which would offset some off the loss and some held other assets that might have gone up, offsetting some of the loss.  However, fixed income today is in a different place and may NOT add much value during a sustained market drop.

From current levels it’s highly unlikely that some investing today will earn the famous 10% return from stocks that has always been promised for long term investors, not that some still aren’t forecasting that.

There are some valuation hawks that are forecasting stock returns under 5% for the next decade.

Let’s compromise and say that returns will be 7.5% on stocks over the coming ten years (this is not my opinion or advice, just an assumption), choose an equity allocation above and ask yourself whether or not you could handle such a drawdown and whether it would be worth it for the extra return.

Scott Dauenhauer CFP, MSFP, AIF


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