For this mental exercise, let’s consider Sarah, a 25-year-old who plans to invest steadily for 40 years until she is 65, and then plans to draw on her investments for retirement. As I mentioned earlier, stock markets are currently near all-time highs. Given the current elevated level of stock market prices, “strategists” expect long-term future returns to be about 7% per year for a diversified, all-equity portfolio (instead of the historically higher long-term average all-equity return of 10% per year experienced over the last 90 years). Based on this information, Sarah invests $1,000 today, and then heads out on a one-week vacation to a remote location with no wifi.
Now, let’s say there is a surprise Bear attack that causes the stock market to drop 22.6% in one day (exactly like what happened on Black Monday on October 19, 1987). Then, let’s say the market continues to drop another 8% later that week, for a total drop of 30%.
When Sarah returns from vacation and logs into her investment portfolio account, she is devastated! Her $1,000 initial investment has just dropped 30% to $700.
How will she cope?
Stay with me here, this explanation requires a bit of a story.
First, let’s start by saying the “strategists” are correct that the long-term forecast of a 7% average all-equity return per year is appropriate.
Second, over the course of Sarah’s 40-year investment horizon, Sarah and the “strategists” know to expect an average of one Bear attack every 3.5 years, or about 11 Bear attacks in total. When those Bears will attack is anyone’s guess. But Sarah’s case was a worst-case scenario – the Bear attacked the day after she invested her money. To be clear, the target forecast of a 7% average all-equity returns per year fully incorporated BOTH some strong Bull markets (strongly rising), AS WELL AS Bear attack markets (strongly falling).
If there were no such thing as Bull or Bear markets, then Sarah’s $1,000 would steadily grow at 7% per year to a total of about $15,000 in 40 years.
Unfortunately for Sarah, equity markets are NOT smooth, and she encountered a Bear attack on day two of her investing career. The first of the 11 EXPECTED Bear attacks lopped 30% off Sarah’s portfolio, and left her with $700.
For Sarah to reach the originally expected $15,000 target (based on a 7% average returns per year and 11 postulated Bear markets), Sarah’s smaller $700 portfolio MUST grow at 8% per year to reach the $15,000 target. In addition, all the money Sarah invests immediately following the Bear attack will also grow at a long-term average of 8%. This of course makes sense. The higher (i.e., more expensive) the current stock market is, the lower the expected future returns. Conversely, the lower the current stock market is, the higher the expected future returns.
Like the reliable quirkiness of what Einstein calls “Mankind’s Greatest Discovery” (i.e., compound interest), and the associated Rule of 72 for every Bear attack that causes the stock market to drop by 30%, the long-term (i.e., 40-year) expected future returns will be 1% higher than they would have been before the Bear attack. For every Big Bear attack that causes the stock market to drop by about 50%, the expected future returns from that new lower level will be 2% higher than they would have been before the Bear attack. This quirky relationship between Bear attacks and long-term (i.e., 40-year) expected future returns is consistent with Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE) technical research.