This article first appeared in the Morningstar ETFInvestor – August 2013.
Let’s talk about losing money. I think everyone should think about how much money they can lose and whether they can tolerate those losses. Unless you’re in cash and cashlike investments, odds are you will, at some point, see a big chunk of your worth evaporate. In happy times, like now, investors tend to grossly underestimate the probability and severity of losses, and they overestimate their tolerance for pain.
The sharp lessons of history are a potent antidote to the dulling effects of a bull market. From 1926 to 2013, the S&P 500 has drawn down more than 50% of its real value from its most recent peak on at least three occasions: 79% from August 1929 to May 1932, 51.9% from December 1972 to September 1974, and 54% from August 2000 to February 2009. (Only in May of this year did the S&P 500 surpass the after-inflation, total return peak it achieved during the tech bubble.) It seems that every 30 years or so, the stock market takes a beating.
Despite the inevitability of bad times, most investors aren’t prepared for them because they form their expectations of risk on what’s happened in the recent past. That’s like building a house on a floodplain based on the climate over the past few years, ignoring the once-a-decade floods that devastate the area. You don’t want to be in a position where you’re rushing to buy flood insurance as soon as the river starts swelling, or laying sandbags around your abode while the flood waters are already lapping at your doorstep, because by then it’s too late.
I think most investors know equities can lose big, because they’ve gone through the tech crash and the financial crisis. But I don’t think most investors know how badly bonds can lose. Many bond investors haven’t experienced a single flood. According to the financial media, the closest thing to a flood that counts happened in 1994, during which the 10-year Treasury went to about 8% from 5.7%. Over that time, an investor in a 10-year Treasury would have experienced a peak-to-trough loss of about 10%. Fortune ran an article titled “The Great Bond Market Massacre.” We recently had investors hyperventilating when the yield on the 10-year rate went to 2.6% from 1.6% in a month. I’d call both paper cuts, to be honest.
A real bond-market massacre began in December 1940 and didn’t stop until August 1952, a time over which intermediate-term U.S. Treasury bonds experienced a peak-to-trough loss of 37.8% after inflation and including reinvested coupons. The U.S. government paid back its accumulated wartime debts in debased dollars.
The United States isn’t unique. The United Kingdom did the same thing several times over its long history. (It costs a lot of money to take over the world and maintain a global empire.) It’s simply the nature of governments to inflate away their big debts whenever possible.
However, inflationary defaults happen in bursts. Economies can enjoy decades of relative stability, which lulls investors into narrowing their perspective of what counts as possible or extraordinary. I think that’s true of many investors today. A fast rise in interest rates isn’t unprecedented.
So what’s the point of talking about the unpleasant, scary history of financial markets? It’s not to scare you into cash, which would all but doom the long-run investor to lose money at today’s miserly yields. It’s to argue that the only real protection involves accepting equity risk and managing it intelligently, buying when equities are cheap and lightening up on them when they’re not. In my opinion, there’s no more reliable way to maintain purchasing power.
Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor.
