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Stingy Investor Tip Sheet

Sell, Sell, Sell!

Ok, I admit it. I occasionally have the villainous desire to go on TV during a market panic and shout "Sell, Sell, Sell!" I could then rant about how the markets are particularly dangerous. I'd end the tirade with a less manic, "because I want to buy cheap stocks."

But after talking with investors over the last week, my days of villainy are over. I'd feel badly for anyone who listened to the 'sell now' part of my speech and failed to notice the 'because I want to buy' part.

Indeed, I'm a little reluctant to even post this quick look at the history of stock market declines in the United States. I'm not really interested in inspiring panic. But I do want to take a look at what history has to say about the downside risk for stocks.

To focus on the downside, I start with the monthly S&P500 data collected by Robert Shiller. I then calculate how much the S&P500 price index has fallen from its prior peak. You can see the results in the accompanying graph which shows the downside faced by index investors over various periods.

S&P500 Downside Risk: Decline From Peak
[click to enlarge]

In most cases, bear markets for the S&P500 were painful but relatively quick. They may have lasted for, say, a few years. The granddaddy of declines, the 1929 crash, was a different beast and it sent the market down for decades.

But the figures presented do not include dividends. That's not a big deal when the crashes are short lived but dividends do matter for the 1929 crash. Indeed, they decreased the time needed for the S&P500 to recovery by many years. Nonetheless, I think the graph provides a visceral sense of the historical downside risk for the S&P500.

If the past is a guide, index investors should expect 40% declines to be relatively common. The big decline of 1929 shows that 'once in a century' events can really hurt. Even worse, we don't know if 1929-style events actually occur only once in a century. Maybe they tend to occur once every 200 years? Maybe they occur more frequently and we've just gotten lucky? There is also no saying that a 90% decline is the worst that can happen for stocks.

On the brighter side, stock markets do tend to recover given sufficient time. The same can not be said for bonds but that's a topic for another day.

09/22/2008   3:00 PM EST   Permlink   save & shareMarkets

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