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.
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.
SEVEN CORE ASSET CLASSES
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.
ENDURING THE RECOVERY PERIOD
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.
HAVING A STEADY HAND
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.