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How Much Pain Can You Take? by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc. June 15, 2007 For important footnotes and disclosures, please see the bottom of this article. Could you recover from a 25% drop in the value of your portfolio? How about a 50% drop? It may be tougher—and take longer—than you think. Unfortunately, many investors are unaware just how devastating such an event could be and aren't properly protected against it. Here, we'll show you how to assess just how susceptible your portfolio is to major losses and what you can do to avoid them. Reading the 'rithmetic of recoveries Consider this real-life example of what it can take to recover from a market fall: In the 25 months prior to September 2002, the S&P 500® index dropped 45%. Through November 2004, the market had recovered 50%. While it's tempting to think that a gain of 50% after 26 months might have restored the market to its 2000 peak, the math of investment returns tells us that, in fact, a gain of 81% was needed to recover fully—which, in this case, took 49 months to reach in October 2006. This is not unusual. Using a realistic return expectation for large-cap stocks of about 8.5% over the long term, it would take more than seven years to grow 81% at that rate!  As of: December 31, 2006. Source: Schwab Center for Investment Research It's one thing to calculate portfolio losses in percentages, but we live our retirement in dollars. A $100,000 investment in our earlier example dropped to $55,267 and only made it back up to $100,528 with the 82% gain. The time to recover would be increased dramatically if you were withdrawing from your portfolio during this time. So gauge the level of your losses in dollar terms, as well. Could it happen to you? That depends on your portfolio. Since 1970, the S&P 500 has had eight annual losses. Half of those were drops of greater than 10%—the worst was in 1974, with a loss of 26%. And 45 of the 148 quarters since 1970 have been negative, with 10 dropping more than 10%. Losses like these can be magnified by common portfolio errors, such as poor asset allocation or concentrated stock or sector positions. We looked at more than 2 million self-guided client portfolios and found that nearly one-third of them had a concentrated stock position of greater than 20%.1 Concentrations, even of blue-chip stocks, can be dangerous—24% of the stocks in the S&P 500 were down in 2006, a year when that index's price appreciated 13% overall. An unexpected downturn can be particularly painful for those in or near retirement, as they may not have the time to recover from such an event. It can mean postponing retirement or reducing future retirement spending. To guard against that unwelcome outcome, it's important to control and monitor the risk level in your portfolio. Of course, it's also very helpful to have a cushion provided by additional retirement savings. How to protect your portfolio The good news is that a portfolio diversified across and within asset classes can help to mitigate the pain of losses, because one asset class may be rising as another is falling. Guess what bonds did while stocks plummeted 45% in that bear market of 2002? Gained 23%! As the table, "Diversify and Lose Less," below illustrates, a moderate portfolio with 60% in stocks and the rest in bonds and cash had only six negative years since 1970. And only one of those losses was greater than 10%, with 1974 showing a drop of only 13%.
Concentrated stock holdings, misaligned asset allocation and lack of diversification can send investors who might otherwise be conservative into a high-risk category. So let us help you. A Schwab consultant can work with you to get the risk level of your portfolio aligned with your personal risk tolerance. Then, your Schwab consultant can help you maintain a well-diversified portfolio of high-quality securities, spread across stocks, bonds, and cash products to help you ease the pain of a downturn in the market. Important Disclosures 1. Data from 2,231,937 Schwab client portfolios as of February 28, 2007, excluding those in Schwab Private Client™. 2. Data provided by Ibbotson Associates, Inc. Returns include reinvestment of dividends and interest. The portfolios are weighted averages of indexes representing each asset class and are rebalanced annually. Aggressive is 50% large-cap stocks, 20% small-cap stocks, 25% international stocks and 5% cash. Moderate is 35% large-cap stocks, 10% small-cap stocks, 15% international stocks, 35% bonds and 5% cash. Conservative is 15% large-cap stocks, 5% international stocks, 50% bonds and 30% cash. The indexes representing each asset class are S&P 500 index (large-cap stocks), Russell 2000 Index (small-cap stocks); MSCI EAFE Net of Taxes (international stocks), Lehman Brothers U.S. Aggregate Bond Index (bonds) and Citigroup 3-Month U.S. Treasury Bills Index (cash). CRSP 6–8 was used for small-cap stocks prior to 1979; Ibbotson Intermediate-Term Government Bond Index was used for bonds prior to 1976; and Ibbotson 30-Day U.S. Treasury Bills Index was used for cash prior to 1978. The S&P 500 index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Diversification strategies do not assure a profit and do not protect against losses in declining markets. Sector investing may involve a greater degree of risk than an investment with broader diversification. Changes in interest rates can affect a bond's market value prior to call or maturity. Bonds are subject to credit, interest rate and inflation risks. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. (0607-6334) Return to Top |
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