You’ve heard it before. Investing in stocks is risky. If it didn’t involve any risk, then you couldn’t expect any significant return. That’s why risk-free investments such as CDs and savings accounts only yield around 1-2%. Makes sense, right?
However, you need to understand HOW risky it is to invest in stocks, so you can decide whether to invest at all, and how aggressively to invest.
A Look at History
Let’s look at historical data for the S&P 500 index (a measure of total stock market performance). Of course, past performance does not tell you what is going to happen in the future, but it is the best we have.
The graph below shows the value of the S&P 500 index from 1950 to current using a linear scale. This makes it easy to see that in 2007-2008, the market dropped over 50% in value. It did recover, but for that period of time, many people lost half of their net worth.
The linear scale makes it difficult to see what happened when the S&P 500 index was much lower in value. For this, let’s look at a logarithmic scale. In this scale, a 50% drop visually looks much less than a 50% drop, so you need to pay attention to the y-axis.
In any case, you can see that the S&P 500 has dropped large amounts >30-40% several times in the past. You can also see that in some cases, it can take nearly 10 years for the S&P 500 to recover after a crash. For example, during the crash of 1973, the value of the S&P 500 didn’t return to its pre-crash value until 1981.
Therefore, if history is any indication, you need to understand that it is possible for the stock market to (1) lose 50% of its value and (2) take up to 10 years to return to it’s pre-crash value. It is also possible that the stock market could do even worse than this, but let’s not get too pessimistic.
Choose your Risk Carefully
The point of going over all this is not to scare you away from investing in stocks. Rather it is to help you determine your risk tolerance. If it is possible for the stock market to decline 50% in value, then perhaps you don’t want to have all your money in the stock market. For example, if you only had 60% of your assets in stocks (40% in bonds), then you might only lose 30% of your net worth if stocks declined 50%. This is also why it might be prudent to reduce stock exposure as you near retirement.
Preparing for the Next Market Downturn
The stock market goes up and down. When it goes down, it often crashes. You should prepare yourself emotionally for this, so that you don’t sell everything when the markets are down, thus locking in losses. It may be helpful to think of the value of your portfolio as some percentage of it’s actual value, to account for potential loss in a market crash. For example, if you have a $1 million portfolio with 80% stocks, this may only be worth $600,000 in a deep market decline.
If you want to outpace inflation, you need to take some risk in your portfolio. In other words, you need to invest in stocks. However, it is important to be realistic with yourself about how much risk you are willing to accept. Moreover, in order to avoid selling stocks in a down market, you need to emotionally prepare for a sharp decline. Your portfolio value is in rapid flux and its value today may not be its value tomorrow.