The Price of Admission

By Charlie Bilello

22 Jan 2021

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).

Data Sources: YCharts, Bloomberg, Compound

Since the end of 2008, the S&P 500 has gained 449% with only one down year, a small loss of 4.4% in 2018. That’s a gain of 15% per year, compounded over 12 years.

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

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Seems like an easy ride, but any investor living through the last 12 years will tell you otherwise.

There were 27 corrections since the March 2009 low of more than 5%. Of these, 10 were larger than 10%, 3 exceeded 20%, and 1 was more than 30%.

Data Sources: YCharts, Compound

Before investing, many will tell you that they can easily stomach a 20-30% 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…

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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.

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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”)…

If you held your position through 2018, the biggest test since the financial crisis would come in early 2020.

The covid-19 crash would take stocks down 35% in a little over a month, the fastest bear market in history.

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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…

What’s the commonality of 2011, 2018, and 2020?

The large declines that occurred in these years 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 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.

Data Source: YCharts, Bloomberg Barclays, Compound

Importantly, the equity premium is not static. And it is by no means guaranteed, particularly in the short run, but also over longer periods.

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.

Data Sources: Bloomberg, Compound

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.

Data Sources: YCharts, Bloomberg, Compound

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.

Data Sources: YCharts, Bloomberg, Compound

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.

Data Sources: NBER, Bloomberg, YCharts, Compound

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.

Source: Compound

As I’m writing this, losses are probably the last thing on anyone’s mind, as the memories of last March have long faded. The Dow, S&P 500, and Nasdaq 100 are trading at all-time highs, day after day. New IPOs and SPACs are all the rage, and risk appetite from investors has rarely been higher.

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, as long as you’re prepared for it. For uncertainty is a feature of equity investments, 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

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