Fear of Fall­ing

You know how much clients hate it when mar­kets suf­fer a steep de­cline. Here are key facts to help them cope when as­set classes are un­der­wa­ter.

Financial Planning - - CONTENT - By Craig L. Is­raelsen

Clients hate it when stocks plunge. Here are facts to help them cope.

CLIENTS — AND EVEN SOME AD­VI­SORS — OVERREACT to mar­ket losses, even though they oc­cur far less fre­quently than gains.

Are they on to some­thing? Con­sider the long­time per­for­mance of the S&P 500. This in­dex has pro­duced a pos­i­tive an­nual re­turn about 75% of the time since 1926. Even af­ter ac­count­ing for in­fla­tion, it has had pos­i­tive an­nual real returns roughly 70% of the time.

Think of it this way: An ex­tra­or­di­nary bat­ting av­er­age in base­ball is .400, but in play­ing the stock mar­ket game, in­vestors have had a bat­ting av­er­age of .700 over the last nine decades.


But look past the S&P 500. How of­ten do other as­set classes have neg­a­tive returns? And, once a loss oc­curs, how long does it take for an as­set class to re­cover? These are two ques­tions worth a close ex­am­i­na­tion.

To ex­plore, we’ll fo­cus on seven core as­set classes that are of­ten used in in­vest­ment port­fo­lios. Each of these as­set classes has a per­for­mance his­tory go­ing back to 1970: large­cap U.S. stocks, small-cap U.S. stocks, non-u.s. stocks, real es­tate, com­modi­ties, U.S. bonds and cash.

To mea­sure the per­for­mance of these classes, large-cap stocks will be rep­re­sented by the S&P 500, small-cap stocks by the Rus­sell 2000, non-u.s. stocks by the MSCI EAFE in­dex, real es­tate by the Dow Jones U.S. Se­lect REIT in­dex, com­modi­ties by the S&P Gold­man Sachs Com­mod­ity in­dex, bonds by the Bar­clays U.S. Ag­gre­gate Bond in­dex and cash by the 90-day Trea­sury bill. We will also ex­am­ine the be­hav­ior of a port­fo­lio com­posed of all seven in­dexes in equal al­lo­ca­tions of 14.29% (with an­nual re­bal­anc­ing).

As shown in the chart “Sum­mary of As­set Classes,” real es­tate has been the top per­former over­all in the 47-year pe­riod from 1970 to 2016, gen­er­at­ing an av­er­age an­nu­al­ized nom­i­nal re­turn of 11.94% (7.6% af­ter ad­just­ing for in­fla­tion).

More­over, it has achieved pos­i­tive cal­endaryear returns 83% of the time. Af­ter ac­count­ing for in­fla­tion, real es­tate has pro­duced pos­i­tive real returns in 77% of the years.

Real es­tate has pro­duced a neg­a­tive nom­i­nal re­turn just 17% of the time since 1970. That is an out­stand­ing suc­cess ra­tio. The last neg­a­tive cal­en­dar year for real es­tate was 2008, at the height of the fi­nan­cial crisis.

Small-cap U.S. stocks have been the sec­ond-best per­former, with a 47-year an­nu­al­ized nom­i­nal re­turn of 11.02%, 6.72% af­ter in­fla­tion. This as­set class has had a pos­i­tive cal­en­dar-year re­turn 70% of the time over the past 47 years, and 68% of the time af­ter ac­count­ing for in­fla­tion.

Large-cap U.S. stock had a 47-year an­nu­al­ized re­turn of 10.31% and real re­turn of 6.03%. The S&P 500 had pos­i­tive nom­i­nal returns 81% of the time and pos­i­tive real returns 72% of the time. The last neg­a­tive year for the in­dex was also in 2008.

It’s worth not­ing that cash shows pos­i­tive nom­i­nal returns for all 47 years, but, af­ter ac­count­ing for in­fla­tion, it had a pos­i­tive real re­turn only 60% of the time — the low­est per­cent­age among all seven as­set classes.

A port­fo­lio with equal al­lo­ca­tions of all seven as­set classes has per­formed ad­mirably over the past 47 years, pro­duc­ing an av­er­age an­nu­al­ized nom­i­nal re­turn of 9.82%, with a stan­dard de­vi­a­tion of 10.16%. The stan­dard de­vi­a­tion for the mul­ti­as­set port­fo­lio has been dra­mat­i­cally lower than that for any of the so­called per­for­mance en­gines (real es­tate, U.S. small-cap stocks, U.S. large-cap stocks, in­ter­na­tional stocks and com­modi­ties). Ad­di­tion­ally, the seven-as­set port­fo­lio had a pos­i­tive nom­i­nal re­turn 87% of the time, and a pos­i­tive real re­turn 74% of the time.


Over the past 47 years, each core as­set class has pro­duced a pos­i­tive re­turn at least 70% of the time be­fore in­fla­tion, and at least 60% of the time af­ter in­fla­tion. But, de­spite hav­ing very good bat­ting av­er­ages, these as­set classes do, of course, ex­pe­ri­ence neg­a­tive returns, which trans­late into tem­po­rary port­fo­lio losses. Over time, these core as­set classes have al­ways re­cov­ered.

The ques­tion is: Do ad­vi­sors and their clients have the per­sis­tence to en­dure the re­cov­ery pe­riod?

Clearly, it is a chal­lenge. Port­fo­lio losses don’t play fair, be­cause it takes a pro­por­tion-

If a port­fo­lio is ef­fec­tively di­ver­si­fied, the odds of a sub­stan­tial loss are rel­a­tively low. If one oc­curs, how­ever, the so­lu­tion is to have a steady hand.

ally big­ger gain to break even from a loss. Thus, even though all the key as­set classes have pos­i­tive nom­i­nal and real returns most of the time, the losses that they do ex­pe­ri­ence can be dis­pro­por­tion­ately painful.

This sit­u­a­tion is shown in

“The Math of Loss and Re­cov­ery.” As the port­fo­lio de­cline in­creases, the needed gain to re­store the loss also in­creases.

For ex­am­ple, a port­fo­lio loss of

35% re­quires a 53.8% cu­mu­la­tive gain to re­store the port­fo­lio to its value prior to the loss.

A loss of 50% re­quires a

100% gain to break even. A 75% loss re­quires a 300% gain to re­cover the lost ac­count value.

The pri­mary goal of a di­ver­si­fied in­vest­ment port­fo­lio should be to pro­vide a rea­son­able rate of re­turn while min­i­miz­ing the fre­quency and mag­ni­tude of losses.


The S&P 500 lost 37% in 2008, but a di­ver­si­fied seven-as­set port­fo­lio fared bet­ter, with a loss of only 27.6%. As the chart shows, a loss of 40% re­quires a 67% gain to break even, while a loss of 25% re­quires a gain of only 33% to fully re­cover.

It’s im­por­tant that ad­vi­sors have a steady hand dur­ing pe­ri­ods of losses. The re­al­ity is that losses oc­cur, but so does re­cov­ery. What’s needed most when mar­kets are in a down pe­riod is pa­tience and per­spec­tive from both ad­vi­sors and clients.

This is shown in the ta­ble “Down­turns and Re­cov­er­ies,” which fo­cuses on large-cap stocks and a seven-as­set port­fo­lio. Over the past 37 years, us­ing monthly per­for­mance data from 1980 through 2016, there is a 15% chance that U.S. large-cap stocks will lose up to 5% in a 12- month pe­riod. There is an 11% chance of a loss of up to 10%, a 6% chance of a loss of up to 15% and a 5% chance of a loss of up to 20% within a 12-month pe­riod.

Next, let’s look at how of­ten the amount lost has been re­cov­ered within 36 months, also go­ing back to 1980. Af­ter ex­pe­ri­enc­ing a loss of 5%, the S&P 500 has 83.4% of the time gen­er­ated the needed cu­mu­la­tive re­cov­ery re­turn of 5.3% within a 36-month pe­riod.

From a loss of 10%, the needed re­turn is 11.1%, which the S&P 500 has man­aged 80.4% of the time. A 15% loss re­quires a 17.6% cu­mu­la­tive gain for re­cov­ery, which the S&P 500 has ac­com­plished 77.8% of the time. Fi­nally, a loss of 20% re­quires a 25% cu­mu­la­tive gain to break even, and the S&P 500 has gen­er­ated this needed re­turn 75.6% of the time.

There is only a 3% chance that a well­diver­si­fied port­fo­lio will ex­pe­ri­ence a 15% loss dur­ing a 12-month pe­riod. The good news is that, based on his­tor­i­cal data, there is an 80.9% chance this di­ver­si­fied port­fo­lio will fully re­cover within 36 months.

In light of this his­tory, ad­vi­sors can help clients get through tough mar­ket times by ex­plain­ing that when it comes to losses, they are typ­i­cally not long-last­ing if in­vestors don’t aban­don a di­ver­si­fied port­fo­lio.

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