Monday, 4 July 2011

Investing Risk: Historical Worst Volatility, Business Cycles, Crashes and Crises

Last week, we explained how the various investing risks come about but only gave a general idea of their extent and magnitude. It's time to rectify that by attaching some numbers to the risks. History will be our guide. We'll cover the risks in several posts. This first post will deal with downward market moves.

Rather than try to split hairs about what distinguishes short-term volatility from business cycle moves, crashes or crises we have lumped all these market events together. The important thing to know is: how far down can down be and how long does it take to recover losses?

S&P 500 USA 1928 to 2010 in US dollars, i.e. not converted into the Canadian dollars that a Canadian investor would experience
  • Worst one-year drop: -43.8% (1931) then -36.6% (2008)
  • Max peak to bottom drop (drawdown): -79% real/inflation-adjusted (1929-32) shown as blue area in the chart below; Recovery period to 1929 peak - 1945 / 16 years
  • Tech Bubble Crash: -52% real drawdown 2000 to 2002, Recovery not complete
  • Financial Crisis: -48% real drawdown 2007 to 2009, Recovery not complete
TSX Composite Canada 1958 to 2010 -
  • Worst one-year drop: -33.0% (2008), then -25.9% (1974)
  • Worst drawdown real/inflation-adjusted: -39.6% (1973-4), Recovery period 6 years
  • Total down years nominal dollars (1958 to 2010): 14 years / 26%
  • Total down years real/inflation-adjusted (1970 to 2010): 13 years / 32%
T-Bills -
Worst year USA (1928 to 2010): 0.03% return (1940)
Worst year Canada (1970 to 2010): 0.5% return (both 2009 and 2010)

Treasury Long Term Bonds -
Worst one-year drop USA (1928 to 2010): -11.1% (2009)
Worst one-year drop Canada (1970 to 2010): -7.4% (1994)
Maximum real drawdown USA (1900 to 2010): -67% (1940 to 1981) shown as red area in the chart above, Recovery period to 1991 - 51 years!
Maximum real drawdown Canada (1970 to 2010): -37.9% (1973), Recovery period 12 years

Some of the above numbers look quite scary indeed, especially the effect of drawdowns and extended recovery periods. One might be tempted to invest only in Treasury Bills. They are low risk in terms of annual nominal returns ... but there is also inflation to consider, which creates losses in real value in many years. Inflation is another risk we will quantify in a another future post.

It's also good to remember that the above are the worst historical results. Averages over extended periods of years are positive and many years or periods offer large upward moves.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

USA Returns: Aswath Damodaran, Professor of Finance, NY University, Historical Returns on Stocks, Bonds and Bills - United States
USA Drawdowns: Credit Suisse Global Investment Returns Yearbook 2011, compiled by Elroy Dimson, Paul Marsh and Mike Staunton
Canada Returns: Libra Investment Management, Spreadsheet of Annual Returns
Canada Drawdowns: Stingy Investor, Asset Mixer
World Stock and Bond Drawdowns: Wade Pfau's Retirement Researcher blog post 13 January 2014

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