Common Myths About Stock Market Risk

Over the years, we have found that most investors have quite exaggerated views about stock market risks, especially after 2008. While we do always advocate low risk investing here in MDJ, primarily by investing in dividend stocks, we also wanted to touch on the subject again of operating in an exaggerated environment such as the one we have now in 2021.

This time around we’ll deal with bear markets and how to handle a market crash. For further reading you can check out these articles about how does the stock market work in Canada, and how to hedge against inflation by investing in stocks.

bear markets has created fear, much of which is completely unrealistic, based on actual market history. These exaggerated fears have seriously negative results for many Canadians:

1. Being too cautious during the great buying opportunities when markets are low.
2. Investing far too conservatively to be able to reach their retirement goal.

Here are the facts regarding some of the most common misconceptions and myths.

1. The stock market is so risky that it can fall by 50-90%.

The short term risks are definitely significant, but the crash of 2008 has many people believing the risks are much higher than they actually are. When you invest in stocks, you need to understand that market losses of 30-40% happen (rarely), but losses of 50-90% in one year have never happened.

The worst losses, both single and multiple calendar years (excluding the 1930s) are between 30-40%. The worst calendar periods from top to bottom were 1973-74 and 2000-2, both of which were declines of 38%. ¹

Monthly or daily data, or periods less than a year, may produce somewhat more extreme results, including some between 40-50%. Using monthly data in Canadian dollars, the worst 1-year period in the last 25 years has been -31.0% for the global stock market (MSCI World), -30.6% for the U.S. (S&P500) and -36.6% in Canada (TSX60). 4 Newspaper stories showing losses between 43-50% are based on the worst day and usually have been for periods less than a year, but also exclude dividends.

Occasionally, currency can make this worse. The most glaring example is the S&P500 in Canadian dollars being down 32% from 1999-2008, but most of this was the currency. Not only is this is the only 10-year negative period in the S&P500 (excluding the 1930s) since 1871, but currency made it even worse. The market was also down 14% (1.5%/year), but the U.S. dollar was down another 19%. ^1&4

Including the 1930s, the worst calendar period was 1929-32 – 4 negative years in a row with a total loss of 63%. The total loss from the highest to lowest day was 83%, but huge gains just before and after this decline limited the calendar loss to 63%. 1 Our opinion is that the 1930s period will not happen again. Governments made it far worse after the initial crash by raising taxes and interest rates, and not standing behind bank deposits, which are huge mistakes they would not make again.

Therefore, assuming the future is like the last 140 years (excluding the 1930s), the biggest losses we should reasonably expect for periods one year or longer are 30-40%. There have been only 3 of these since the 1930s, but 2 of them were this decade. ¹

2. “Secular bear markets” (periods of more than 15 years with no growth) have happened.

Quite a few articles and books have been published showing bands of no growth from 1929-49 and 1966-82. However, all these graphs excluded dividends from the returns for some reason, even though they are a significant part of stock market returns. The actual returns during these periods were 3.7% and 6.7%/year. ¹

Despite widespread belief, when you include the total return of the stock market, you will see that secular bear markets have never happened! It is a popular myth.

Even the 1930s were not a sideways market. We really had a 4-year huge crash followed by an 11-year massive recovery.

3. The stock market sometimes crashes and takes decades to recover.

One of the biggest fears of most investors is a 10-20 year period of no growth and what that can do to their retirement plan. This fear is grossly exaggerated, both because it has not happened in history and because of the pattern of these periods.

The longest period of no growth (excluding the 1930s) was only 10 years (1999-2008).In fact, all 7-year periods had a gain, except for 3 – 1929-42 (14 years), 1999-2008 (10 years) and 1966-74 (9 years). ¹

The pattern of these periods is the other reason that this fear is exaggerated.

Very few people understand how the longer bear markets work. They did not START with a market crash and then take years to recover (again excluding the 1930s). The longest periods with losses ENDED with a large market decline. They were periods of somewhat lower returns that END with a sudden, but short crash. The long periods with no gain for 9 or 10 years were periods that ended with a sharp drop that dipped briefly below the starting level.

The fear is that the market will drop and take 10-20 years to recover. The fact is that the worst periods had a sharp drop that recovered quickly. It was just that the lowest point had briefly dipped below where it had been 9-10 years earlier.

For example, the 9 years from 1966-74 ended with a big loss in 1973-74. The first 7 years (1966-72) had a gain of 7.0%/year. Then came the 2 large losses in 1973-74 that dipped briefly below the January 1966 level. ¹

The only long period with a loss ended in 1974. The 2-year periods ending in 1973 or 1975 both had gains. If you START with the big losses in 1973-74, then they had fully recovered in only 2 years by 1976.

In short, while the 9-year period from 1966-74 had a loss, the longest the market stayed down was only 4 years. The 3 declines in that period (1966, 1969 and 1973-74) all saw complete recoveries in 1-2 years! ¹

The only other period of more than 6 years without a gain was the 10 years from 1999-2008, which ended with a big loss in 2008. The 9 years ending the year before (1999-2007) had a gain of 3.6%/year. ¹

The market has not been down for 10 years – only 1.

4. Market recoveries can take many years.

Recent news stories have claimed opinions of market “experts” that believe the markets will take a decade or more to recover from 2008.

However, recoveries from market declines have consistently been surprisingly quick.

From the bottom of the 25 calendar periods with market declines (excluding the 1930s and 2008), the market fully recovered the following year 16 times, in 2 years 6 times, in 3 years 1 time and 4 years 2 times. ¹

So, 88% of declines (22 of 25) had completely recovered in 1 or 2 years. The longest recovery from the bottom was only 4 years! This is far less than most people would think.

Having a previous career in private industry, the fact that recoveries have happened quickly makes complete sense to me. During the recession in 1992, we started a massive effort to restore profits to the normal level. There were weekly cost-cutting meetings with every single cost examined and every idea to reduce headcount considered. We had aggressive promotions to maintain sales, and bid on low margin jobs to keep people working and average down fixed costs. We implemented “Kaizen” (Japanese system of continuous improvement) and ISO9002 (quality management system).

The entire atmosphere was intense and all spending questioned. Profits were back to normal the following year, but all the initiatives were maintained for several years.

This type of major effort to restore profits is the norm in most companies whenever there is a decline in profit or share price, which is the main reason we believe that the stock markets have consistently recovered quickly from declines.

Sources:

1. Our own research by analyzing the calendar total returns of the S&P500 in US dollars since 1871.
2. Classic book “Stocks for the Long Run” by Prof. Jeremy Siegel that has data from 1802-2006.
3. Morningstar as shown in Andex Charts.
4. Morningstar.
5. Toronto Real Estate Board.