The Price of Admission

By Charlie Bilello

12 Feb 2020

When investors think about risk, 2008 is usually the first thing that comes to mind.

And for good reason. It was the worst year that most investors alive today have ever experienced.

With dividends included, the S&P 500 lost 37% in 2008, its largest decline since 1931 (during the Great Depression).

Since the end of 2008, the S&P 500 has gained 351% with only one down year, a small loss of 4.4% in 2018. That’s a gain of 14.7% per year, compounded over 11 years.

This is what a chart of that growth looks like over time…

Seems like an easy ride, but any investor living through the last 11 years will tell you otherwise.

There were 25 corrections since the March 2009 low of more than 5%. Of these, 8 were larger than 10%, and 2 exceeded 20%.

Before investing, many will tell you that they can easily 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 arguing 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 … last time the market fell this much in December was 1931, during the Great Depression”)…

A day after the low, I tweeted the following…

What did I mean by the price of admission?

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 10-Year Treasury Bonds 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-run growth can have large 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 portfolios.

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.

Importantly, the equity premium is not static and is by no means guaranteed, particularly in the short run.

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 9 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), I prefer to convert to dollars. A 50% decline when you have $10,000 invested early in your career is not going to be viewed 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, losses are probably the last thing on your mind. The S&P 500 is trading at yet another all-time high and the Nasdaq 100 is already up over 10% on the year. It’s been almost 8 months since we’ve seen a 5% correction, one of the longest runs ever.

How long will it continue? Nobody knows.

But risk hasn’t been eradicated. There will be another drawdown. And when it comes, you will have no way of knowing if it will be just a 5% pullback, a 10% correction, a 20% decline, or something more.

And that’s ok. Uncertainty is a feature of equities, not a bug.

Bearing that risk is the price of admission for long-term investors, 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

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.

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