With apologies to GoT fans!
October 9, 2007
We’re shortly coming up on an important 10-year anniversary, though probably not one that is top of mind for most people: the high watermark for the S&P 500 prior to the Great Recession. On October 9th, the S&P closed at 1,565.15 but would drop to 676.53 on March 9, 2009, a full 56.8% decline. Ouch. It wouldn’t be back above the October 2007 high watermark again until April 2013, five and a half years later.
At least there was some good news for those who had the discipline to ride out storm. From the low point on March 9, 2009, to today (September 2017), the S&P has returned a total of 270%, or 320% if you include dividends.
A lot of people didn’t have the discipline for one reason or another. Some went to cash for safety as valuations cratered, telling themselves they’d get back in when things weren’t as scary. Or maybe that it’s different this time. Others just had bad timing and had to liquidate holdings to pay for a just started retirement. I’m more interested in the first set of people, since their wounds were largely self inflicted.
Bull Markets Numb You to Risk
We are currently in the 2nd longest bull market in the history of the United States. The only other one to go longer was during the 90s, culminating in the dot com bubble. While bull markets are no doubt a great thing, they inevitably cause people to think that they are geniuses when it comes to investing. Risk tolerance goes out the window as the memory of the last downturn fades further into the past.
How would you react if the declines of ’07-’09 repeated themselves? I’m guessing most people would say they would hold on, but It’s easy to forget how strong the temptation is to bail out of a declining market. Especially when it’s unclear where the bottom really is.
I thought that would be my answer too, but then I observed my level of concern the couple of times the market dipped a few points this year. Given the amount I have invested, each decline cost me at least a couple thousand dollars across all my investment accounts. It bothered me to see my investment portfolio go down when it had consistently gone up for the last 8 years like clockwork.
The fact I was bothered by this also bothered by me. What it meant was there was a disconnect between the level of risk I was taking and my true risk tolerance. I needed to find a way which one of those measures was out of line so I could fix it.
Stress Testing My Investment Portfolio
If you sign up for just about any investment product, they’ll inevitably ask you questions about your risk tolerance. The problem is that it’s usually asked in such a way that you only think about risk in an abstract way.
I think the more valuable way to think about risk is to see how your current portfolio would perform under a historical downturn. That’s what we’re going to be doing below, with my existing asset allocation applied to a hypothetical $1 million portfolio.
Let’s consider a portfolio made up of a couple different asset classes (along with a corresponding index to represent typical returns):
- U.S. Equities (S&P 500 Index)
- International Equities (Vanguard Total International Stock Index)
- U.S. Fixed Income (S&P U.S. Aggregate Bond Index)
- International Fixed Income (S&P International Corporate Bond Index)
- Real Estate/Alternatives (S&P United States REIT)
- Cash (N/A)
Here is how my current investment portfolio breaks down across these different asset classes.
Because the return data for these indices goes back ten years, we can see how each performed on a total return basis during the Great Recession. Please note that I’ve shown total returns inclusive of reinvested dividends where appropriate since they make up a large portion of returns for some asset classes.
While returns have been pretty good since ‘09, look at the size of some of those declines and how long it took individual asset classes to get back to break even. It’s not just how far that prices can fall that cause heartburn, but also how long it takes them to rebound. Also notice that apart from bonds, everything else pretty much fell in lock-step, there really wasn’t a safe place to hide!
Combining these two sources of data will allow me to see exactly how my existing portfolio would respond to a similar stress scenario, and how long it would take to return to break even.
As you can see, my hypothetical $1 million portfolio would have fallen 47.6% if the Great Recession repeated itself, resulting in minimum portfolio value $523k. Some asset classes fell by 60-70%!
Moreover, a lot of that decline would have occurred in the span of about one month. I would have taken more than 1,795 days, nearly 5 years, for me to get back to breakeven for the balance to return to the starting value in the fall of 2008. If I was worried about a few thousand dollars before, this should make me absolutely terrified!
But I’m not terrified. After looking at my own portfolio, I’m leaning towards not changing my asset allocation for a few reasons:
- I made it through the real Great Recession without liquidating any assets/missing the gains on the back end. I was, however, doing it with a much smaller investment portfolio at the time.
- My investment horizon is still decades long. Being in my mid-thirties and currently employed, I have a long time until I have a legitimate need for my investment portfolio to support any living expenses. I can hopefully ride out any downturns before that point comes.
- Moving to a more conservative asset allocation would lessen the declines, but at the expense of future upside. By playing it too safe, I may put myself at risk of an undersized portfolio when I am ready to stop working.
- Running this analysis helps me quantify exactly how bad it can get. By making the potential decline I’m risking known, I can exert some level of control. Even if that control is only in my mind to keep my emotions at bay.
So in the end, my risk wasn’t really out of line, I just wasn’t thinking about my risk tolerance correctly. Now that I know what a real downturn would look like, it’ll be much easier for me to ignore the little hiccups and sleep better at night as a result. Even if we do have another big decline, I can see the light at the end of the tunnel now too.
What Can You Do?
Let’s circle back to the folks with the self-inflicted wounds of not staying invested in the market throughout the downturn and rebound. My guess is they thought all was great when the market was going up, but really didn’t understand how far it could fall if it went down. It’s scary when you lose years, if not decades, worth of investment contributions in a single downturn.
What happened was their asset allocation was out of line with their true risk tolerance. When their portfolios lost more value than they could bear, they sold to stop the bleeding, but then missed the rebound. What they should have done was figure out their risk tolerance and design a portfolio allocation to match. That way they could stay invested throughout and resist the irrational emotional urge to bail.
If a 20% decline would send you over the edge, then build an asset allocation that would only decline 15% under a stressed scenario. The key is to not let your portfolio diverge from your risk tolerance. People get in trouble when they do and make bad decisions as a result.
A Parting Thought
If you had this portfolio and asset allocation, but missed the gains on the other side, you would have lost nearly $600,000 of growth. While it’s true that the portfolio lost almost half its value, it more than made up for it in the subsequent years. In order achieve gains and build long-term wealth, you have to be willing to ride through a few (very) rough patches as well.
Download the PVF Portfolio Stress Test Model
How would your portfolio respond if the Great Recession repeated? Download the PVF Portfolio Stress Test Model to find out. Input the dollars in your portfolio today for each asset class to see what might happen!
Were you surprised how much your portfolio could decline? How do you think about risk tolerance and your asset allocation now?
John started Present Value Finance in 2017 to share his experiences and insights on personal finance to help people make better decisions and take control of their financial lives.
He achieved financial independence in 2016 by walking away from the high stress world of corporate finance to focus on his family. He’s a husband, father, family CFO, and all around finance geek.