It’s been a shaky few weeks for U.S. stocks, and we can only hope that it’s not the start of a long bear market.
I apologise for sounding a negative note, but what if it is? What if U.S. equities are lower in ten years than they are today? It’s a relatively rare occurrence, but it does happen.
Two years ago, the Financial Analysts Journal published a paper by Edward McQuarrie, a professor at Santa Clara University in California, who analysed returns on U.S. stocks from 1792. (1)
McQuarrie found that there were five instances of ten-year periods of U.S. stock losses — in the 120 months ending in February 2009, September 1974, August 1939, June 1921, October 1857 and April 1842. He even found examples of U.S. stocks incurring 20-year losses.
Other countries have also suffered long and savage bear markets. For example, Italian stocks lost 78.2% in the 20 years to 1979; Japanese stocks lost 64.3% in the 20 years ended in 2009; and Norwegian stocks lost 74.1% during the 30 years to 1978.
UK equities have also endured prolonged periods of negative real returns. A notable example was the period from 1900 to 1923, which included the financial panic of 1907, World War 1, post-war austerity and the recession of 1920-21. The 1930s and 1940s were also lost decades for investors in UK stocks.
The impact of negative compounding
If the idea of stocks producing negative returns over one, two or even three decades sounds a little grim, the implications are actually more serious than you might think. Why? Because of the impact of negative compounding.
Of course, compounding is typically associated with wealth growth, but it can also work in reverse, magnifying losses over time.
Imagine two investors, both starting with £100,000. Investor A earns a steady 5% annual return. After ten years, his money will have grown to £179,085; after 20 years to £320,714, and after 30 years to £574,349.
This is the power of positive compounding — modest annual gains accumulating to produce substantial long-term growth.
Investor B, on the other hand, has negative returns of -3% for the first five years, and then annual returns of 6% from the sixth year onwards. His investment will be worth £85,873 after five years, £114,759 after ten, £205,449 after 20, and £367,857 after 30.
In other words, even though, at the 30-year mark, the annual returns of Investor A and Investor B have been identical for the last 25 years, Investor B’s investment is worth £206,492 less — all because of those initial five years of negative returns.
Simply put, losses hurt more than gains help. A 50% loss requires a 100% gain to break even. And even modest negative returns over time can severely impact long-term outcomes.
This is, of course, the same principle as sequencing risk. Someone who retires just before a long bear market is at far greater risk of running out of money in later life than someone who finishes work with a retirement pot exactly the same size, but who experiences a period of flat or positive equity returns early in retirement.
So, what are the best ways to protect yourself from an ice age for equities — a decade or more of falling stock values? Edward McQuarrie’s Santa Clara colleague, Professor Meir Statman, addressed this issue in a recent article in the Wall Street Journal. (2) There are three key things he suggests investors do:
1. Diversify globally
If you aren’t broadly diversified, Statman says, you could lose money over long holding periods even when stock indexes overall deliver gains.
2. Ensure you own the best-performing stocks of the future
As research by Hendrik Bessembinder has shown, the vast bulk of market returns are driven by a very small number of mega-stocks. (3) The more concentrated your portfolio is, the greater the risk of not owning, say Nvidia, Apple or Microsoft. Missing out on just one of the biggest winners of the future could have a very negative impact on your eventual returns.
3. Keep your costs as low as possible
Investment fees are effectively negative returns, so paying high fees in periods when equities produce negative returns is just adding to your losses. The less you pay to invest, the more you keep for yourself, and the higher your net returns will be.
“In short,” Meir Statman concludes, “stocks don’t cease to be risky investments once they are held for decades. But investors can mitigate their losses by investing in the most broadly diversified low-fee index funds and refraining from trading.”
ROBIN POWELL is a freelance journalist and Editor of The Evidence-Based Investor.
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