When it comes to retirement investing, people often think reaching for the best return will bring the best results. What they don’t realize is that as your potential return rises, the level of risk increases as well. Most people don’t realize quite how harmful those risks can be.
It’s not uncommon for investors to think that if they suffer a 20% decline in their portfolio, they’ll need a 20% gain to get back to even. That’s not true, they actually will need 25% to recoup their twenty percent loss. And if they suffered a 50% decline, they’ll need to gain 100% to get back to even. Below is a chart that shows how much a portfolio will have to grow to offset a previous loss.
During the Great Depression in 1929, the stock market declined 85%. The stock market had to climb more than 550% over the next 25 years just to get back to where it was before the crash.
During the Great Recession in 2008, the stock market declined 52% and required roughly 110% in gains to get back to even.
Fortunately, declines of this magnitude are not all that common. Since 1927 there have been 10 periods where the stock market declined 20% or more. On average, that’s one decline of 20% or more every nine years. During five of those instances, stocks fell by 40% or more (once every 18 years). And of those instances, stocks declined by 50% or more (once every 30 years).
Importantly, eighty-percent (8 of 10) of the declines mentioned above occurred while the US Economy was experiencing a Recession. The two exceptions were the Cuban Missile Crisis in the 1960’s and Black Monday Crash in 1987 caused by program trading. In both instances the stock market recovered within 18 months.
Below is a list of each recession since 1927 and the corresponding decline in the stock market.
Recessions are periods when the economy stalls and begins to shrink. As this occurs, companies experience declining sales. They are forced to cut back on expenses and often times lay-off employees. Investors sell their stocks, in fear that they might not get their money back, pushing the overall stock market down.
Instead of trying to predict the direction of the stock market, we focus simply on trying to avoid recessions. While not every decline of 20% or more occurred during recessions, it does account for 80% of them. That’s why we developed our proprietary Business Cycle Indicator. It’s constructed using economic data ranging from interest rates, corporate finance, and employment data. We’ve tested the indicator back to 1968, which is the first year all the necessary data was available. During that time, there have been 7 recessions, and our indicator would have predicted each recession with an average lead time of 13 months. Our Business Cycle Indicator Page has more details on how the indicator works.
Using our Business Cycle Indicator and historical market data, we ran a test to see how well a hypothetical retirement investor would have fared from 1995 to 2016. This period spans the 46% decline in 2001 when the dot-com bubble burst, and the 52% decline during the Financial Crisis. We developed five CycleWise Portfolios varying only in their allocation between stocks and bonds. The table below shows a summary of the results. Visit our Portfolios Page for more details.
Large declines in the stock market are uncommon, but they have a significant impact on investors financial well-being. Most people that are investing for retirement will be invested for 30, 40, or even 50 years. The odds of having to cope with a major stock market decline like those mentioned above are, unfortunately, quite high.
We’re building a better way for investors to reach their retirement goals. Schedule a free consultation to see how our process can put you on-track toward your retirement.