February 9, 2012

How Ugly Can It Get? Helping Clients Prepare for the Future

My previous blog, Preparing Clients for the Ugly Times: Risk and Return, began the exploration of how we can help our clients better understand the investment experience that lies ahead. While we might wish that this was an invariably beautiful experience, we know that things will turn ugly from time to time.

Previously we looked at how often a portfolio might be falling, recovering and rising: falling from a previous high, recovering from a previous low, rising from a previous high. Armed with this information clients will know better what to expect when they review their portfolios, in particular the likelihood that values will be falling.

Now let’s turn to how often and over what periods falls might occur, how deep they might be and how long the portfolio might take to recover. As before, I will be using historical portfolio performance (see note at end of column) on the basis that looking at what would have happened with a portfolio in the past adds concreteness to our clients' understanding of what might lie ahead.

Falls can occur over any period of time—sometimes they are quick and sometimes they are slow. Looking at a particular time period can be misleading. For example, a rolling 12-month period misses the severity of the October 1987 collapse because of the positive returns in the months before and after, and also misses the severity of extended falls like 2007-2009 because the pain doesn't stop when the 12 months are over.

Using the same 30% stocks and 70% stocks portfolios as previously, the charts below provide a summary of all falls that have occurred since January 1, 1972, categorized by length and depth, with falls of 10% or more in red.

Both portfolios suffered a similar number of falls but, perhaps surprisingly, the 70% stocks

portfolio experienced fewer falls than the 30% stocks portfolio. However, for both, most of the falls were less than 10% and lasted for only one month. But as might be expected, the 70% stocks portfolio experienced five times more falls of 10% or more than did the 30% stocks portfolio.

 

Let's look at the Top 10 falls specifically:

 

 

As can be seen, both portfolios turned ugly in the great recession, which produced (nominal) falls 50% greater than the previous worst. If you were unfortunate enough to make a $100,000 investment in a 30% stocks portfolio on October 1, 2007, you would have seen its value fall progressively to $86,000 by February 2009 before recovering over the next seven months. With a 70% stocks portfolio, the fall would have been to $63,000 and it would have taken two years from then to recover.

Broadly, the 70% stocks portfolio's large falls are three times the size and the period for a fall plus recovery is two to four times as long.

Interestingly, elsewhere the 2007/09 falls were not the greatest in living memory. In the U.K., for example, the 1973/74, 1987, 1989/90 and 2000/02 falls were all greater than those of 2007/09.

If we define ugly as a fall of 10% or more, one can say, crudely, that the 70% stocks portfolio is five times more likely to turn ugly and when it does it can be really ugly.

Of course, this is just the downside. There is an upside too!

The Top 10 rises were:

 

Not surprisingly, each of the rises was of greater magnitude than the corresponding fall. What is surprising is that the rises for the 70% stocks portfolio are much closer to those of the 30% stocks portfolio than were the falls. Also, somewhat depressingly, the data provides a reminder that none of the rises occurred in the recent past.

Overall, there is a richness and concreteness to historical data that simply cannot be matched by forward-looking projections. Clients are able to say, "If I had had my portfolio then, this is what I would have experienced." Helping clients understand portfolio risk is one of the most difficult challenges faced by advisors. What has happened in the past is a valuable aid in establishing realistic expectations about what the future may hold.

Portfolio Performance: The data being presented here is from FinaMetrica's historical portfolio performance analysis. The 70% stocks portfolio is 5% cash, 25% fixed interest, 50% US stocks and 20% international stocks, and the 30% stocks portfolio is 10% cash, 60% fixed interest, 20% US stocks and 10% international stocks.

Total return indices are used as proxies for sector performance and the portfolios are rebalanced annually. The period covered is 1st January 1972 to 30 June 2011. More detail of this analysis can be found in the Risk and Return guides under Resources at www.riskprofiling.com

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