You’ve heard it before. Investing in stocks is risky. If it didn’t involve any risk, then you couldn’t expect any significant return. That’s why risk-free investments such as CDs and savings accounts only yield around 1-2%. Makes sense, right?
However, you need to understand HOW risky it is to invest in stocks, so you can decide whether to invest at all, and how aggressively to invest.
A Look at History
Let’s look at historical data for the S&P 500 index (a measure of total stock market performance). Of course, past performance does not tell you what is going to happen in the future, but it is the best we have.
The graph below shows the value of the S&P 500 index from 1950 to current using a linear scale. This makes it easy to see that in 2007-2008, the market dropped over 50% in value. It did recover, but for that period of time, many people lost half of their net worth.
The linear scale makes it difficult to see what happened when the S&P 500 index was much lower in value. For this, let’s look at a logarithmic scale. In this scale, a 50% drop visually looks much less than a 50% drop, so you need to pay attention to the y-axis.
In any case, you can see that the S&P 500 has dropped large amounts >30-40% several times in the past. You can also see that in some cases, it can take nearly 10 years for the S&P 500 to recover after a crash. For example, during the crash of 1973, the value of the S&P 500 didn’t return to its pre-crash value until 1981.
Therefore, if history is any indication, you need to understand that it is possible for the stock market to (1) lose 50% of its value and (2) take up to 10 years to return to it’s pre-crash value. It is also possible that the stock market could do even worse than this, but let’s not get too pessimistic.
Choose your Risk Carefully
The point of going over all this is not to scare you away from investing in stocks. Rather it is to help you determine your risk tolerance. If it is possible for the stock market to decline 50% in value, then perhaps you don’t want to have all your money in the stock market. For example, if you only had 60% of your assets in stocks (40% in bonds), then you might only lose 30% of your net worth if stocks declined 50%. This is also why it might be prudent to reduce stock exposure as you near retirement.
Preparing for the Next Market Downturn
The stock market goes up and down. When it goes down, it often crashes. You should prepare yourself emotionally for this, so that you don’t sell everything when the markets are down, thus locking in losses. It may be helpful to think of the value of your portfolio as some percentage of it’s actual value, to account for potential loss in a market crash. For example, if you have a $1 million portfolio with 80% stocks, this may only be worth $600,000 in a deep market decline.
Bottom Line
If you want to outpace inflation, you need to take some risk in your portfolio. In other words, you need to invest in stocks. However, it is important to be realistic with yourself about how much risk you are willing to accept. Moreover, in order to avoid selling stocks in a down market, you need to emotionally prepare for a sharp decline. Your portfolio value is in rapid flux and its value today may not be its value tomorrow.
Good review of the facts about market drops. So many investors started within the last 9 years that they don’t really know the risks. Although you laid out the probabilities I didn’t see specific advice on how to “emotionally prepare?” Maybe I missed it? Sometimes I panic when markets are crashing but I would like to not do that.
Also, the “possible” upper limit of loss is listed as 50% Of course, more is possible, right? 60 -70 % or more could happen short-term. During the depression, stocks went down 89% and it took nearly 25 years to recover.
Hi Wealthy Doc. Thank you for your feedback. I think the point I was trying to get across is that if you think of your portfolio value not as its current value, but as its POTENTIAL value after a 50% market drop, then you will be more emotionally prepared for that 50% drop.
For example, if you have a $1 million portfolio with 80% stocks, then if stocks drop 50%, you could expect a 40% drop in your overall portfolio. Therefore, if you have a $1 million portfolio with 80% stocks, you really only have a “guaranteed” $600,000 portfolio. It’s a little bit of a pessimistic view, but if you think of your portfolio as valued at only $600,000, then you will be more emotionally prepared if that stock market crash comes to fruition.
If you can’t emotionally handle the idea of your $1 million portfolio being worth only $600,000 after a crash, then you probably need more bonds in your portfolio. If you had a portfolio of 50% stocks and 50% bonds, a 50% drop in the stock market would only deplete your portfolio by 25%, so your $1 million portfolio would be worth $750,000. That might be more emotionally palatable.
And yes, the market could potentially go down by more than 50%, but that would be an apocalyptic type scenario. If someone is worried about a 90% drop in stock prices, I would recommend the Permanent Portfolio. And lots of guns, ammo, and stored food and water.
I am concerned about the markets currently. The CAPE Ratio is quite elevated. I have a huge issue of losing my capital. I know myself better than that by now. I would rather miss a run up than to lose capital at this stage in my investing runway. My ultimate plan is to have about 20-30% of my investable assets in the public equities market. Then I will be fine with buy, hold and pray since it will be a small part of my holdings.
If you’re concerned about losing capital, a relatively low percentage of equities should reduce the possibility of a large and abrupt drop in your net worth. On the other hand, if you don’t take enough risk on the equity side, the purchasing power of your investments could be gradually eroded by inflation. A good balance is key.