Monthly Archives: December 2013

The Bear Ate [Some of] My [Diversified] Portfolio

In the last post we looked at annual declines in the domestic stocks (The Bear Ate My Portfolio).  Let’s see what happens when we add foreign stocks and bonds to the portfolio mix.

First off, I added a new metric to the table – Total Years.  It calculates the number of years that the investment was “dead money” or how long it took to get back to even including both the decline and the subsequent recovery.  To refresh the memory, Exhibit 1 has the numbers for domestic stocks only.

Exhibit 1 – Recent Bear Markets (S&P 500)

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Exhibit 2 looks at how the numbers change if we add foreign stocks (represented by MSCI EAFE index).  To be clear – we are analyzing the portfolio mix for the years when S&P 500 alone had negative returns.  The results are fairly similar to the original.  The biggest difference is that one of the mildly negative years is eliminated (0.4% return in 1977).  This reduces that average duration numbers but actually increases that drawdowns for the last two episodes.

Exhibit 2 – Recent Bear Markets (70% S&P 500 / 30% MSCI EAFE)

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Next table goes a step further and adds domestic investment-grade bonds to the portfolio (Barclays US Aggregate Bond Index).  Results for the 40% domestic stocks / 20% foreign stocks / 40% bonds are show in Exhibit 3.  Two of the periods are eliminated (1977 and 1981), while the other drawdowns become much milder and easier to recover from.

Exhibit 3 – Recent Bear Markets (40/20/40)

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Key Takeaways

The analysis above is just another way of showing that adding bonds to the portfolio reduces its volatility.  This, of course, comes at the price of lower long-term returns.  Thus, investors should construct their portfolios based on the individual risk tolerance and time horizon (how long they can afford to be in “dead money” period without locking in losses).

P.S.

As an aside, I wanted to take a look at how the all-domestic stock portfolio fared during the Great Depression.  As you can imagine, it was a rather difficult period for stock investors (Exhibit 4).  Starting in 1929, the initial drop through 1932 was 64.2% and required a whopping 180% return to break even.  It took another four years to do that resulting in an eight-year period of “dead money”.  Additionally, another leg down started in 1937 and didn’t recover until 1943.  So with the exception of a brief positive blip, the market stayed under water from 1929 to 1943 or full 15 years!  Of course, that was the absolutely worst investing period in the modern era and it’s not likely to be repeated any time soon.

Exhibit 4 – Great Depression Market Performance

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The Bear Ate My Portfolio

Bear markets occur fairly frequently and are an integral part of investing.  Nonetheless, most investors never learn to accept them regardless of how many cycles they have lived through.  The math of recovering from a portfolio drawdown is unappealing and sometimes downright scary.  For example, it takes 67% increase in the portfolio to recover from a 40% drop and a 100% to break even on a 50% decline (Exhibit 1).

Exhibit 1 – Returns Required to Make Up Portfolio Losses

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Most common definition of a bear market in stocks is a 20% drop from the high point.  Sometimes these severe corrections last for years, sometimes they are over in a few months.  Most professional investors analyze bear market top to bottom and not the annual returns.  There is plenty of analysis online that provides these data, you can see an example here or stories with more color here.

However, individual investors tend to look at portfolio returns in terms of years.  For example, 2012 was a good year. 2008 most definitely was a bad year, while 2009 was a great year that didn’t feel like one.  Given our recent history of two major bear markets in the 2000’s decade, one can be forgiven for thinking that markets are “always” crashing and the good years are few and far between.  That is not true.  As shown in Exhibit 2, there were nine negative years for the S&P 500 (proxy for the U.S. stock market) out of 44 since 1970.  Going back even farther to 1930’s, the last decade was not typical and had more negative years than normally (Exhibit 3).

Exhibit 2

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Exhibit 3 – Number of Negative Years by Decade

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Let’s take a look at couple of recent bear markets and see how long it took to recover from them.  If you started 2008 with $100,000 invested in stocks (S&P 500), you would end the year with $63,000 after a steep 37% drop.  The next few years had positive returns and by the end of 2012, the investor was at $108,579 or 8.6% ahead (Exhibit 4).  It took four years to recover (2009-2012) and the ride didn’t feel very nice despite the eventual comeback.  Likewise, the prior drop spanned three years and by the end of 2002 we were down 37.6%, again requiring 60% return to break even.  Once more, it took four years go get there.

Exhibit 4 – Bear Market Drawdown and Recovery

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In the past 44 years, we had six periods of at least one full negative year for the S&P.  They lasted 1.5 years on average and took 2.3 years for a recovery (Exhibit 5).  Three of them very fairly mild, while the other three were quite severe and required 60% return to “climb out of the hole”.  Two out of three severe periods occurred in 2000’s and still feel very fresh.  Many investors are still having a hard time trusting stocks and are sitting on the sidelines in cash.

Exhibit 5 – Recent Bear Market History

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I’m not trying to minimize the impact of bear markets, they can be vicious and tough to deal with especially for older investors.  Nevertheless, the markets inevitably recover if you stay the course.  The real damage to the portfolio occurs when people try to time the market, sell at the bottom and wait way too long to get back in.

In the next post, I’ll take a look at how adding international stocks and bonds to the portfolio changes the numbers.