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)
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)
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)
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).
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