Why market crashes can be worse than mediocre returns

While we tend to focus on sharp market crashes, sudden declines that recover quickly within just a year or few are not necessarily problematic.

What is far more destructive are extended periods of mediocre returns. Michael Kitces explains.

With two  market ‘crashes’ in the past decade, prospective baby boomer retirees have grown increasingly afraid of the risk that the next market crash could topple their retirement if it comes at the wrong time.

Yet the reality is that failure is dictated not simply by the magnitude of the market decline, but the speed at which it recovers.

As a result, while clients are increasingly obsessed about the risk of a sharp decline in the markets (a so-called black swan event), the true danger is actually an extended period of merely mediocre results that are uncommon but not rare.

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A misconception has become embedded in the mind of financial planners – and investors – about what really does and does not cause a retirement plan to run out of money.  

Impact of ‘crashes’

For instance, assume the client has a balanced portfolio, with a long-term expected return of 8 per cent, and a standard deviation of 15 per cent (shown as the ‘normal’ portfolio).

Now look at three potential ‘problem’ scenarios, each representing a two standard deviation event over a one, five and 10-year time horizon, respectively.

1. In a market crash, the portfolio drops 22 per cent in a year, and then rallies almost 50 per cent the following year (albeit from a lower base) to get back to the original growth rate – this is the 1-year dip portfolio in the graph.
2. In an extended bear market, the portfolio falls by 5.4 per year for five years. Then the portfolio rallies a huge 23.3 per cent per year for the next five years to get back to the original growth trend – this is the 5-year dip portfolio in the graph.
3. In a protracted, difficult market environment, the portfolio declines by only 1.5 per cent per year but for 10 years. As the markets eventually hit a valuation bottom, the portfolio rallies at 18.4 per cent per year for the next 10 years, finally recovering back to the original growth pace after 20 years – this is the 10-year dip portfolio in the graph.

These would be results that are uncommon but entirely probable in a typical Monte Carlo analysis – although notably clients tend to focus much more on the first scenario (sharp market decline) than the third (protracted slightly-declining market).

Ultimately by year 21, all of the portfolios are back on the track, with an initial $1,000,000 investment turned into $4,500,000, either by a fast decline with a fast recovery or a slower decline with a slower recovery.

But this assumes the client stays invested, with no cash flows in and out of the portfolio. Of course, if the client has no need to take any distributions from the portfolio, there is time to wait.  

Impact of withdrawals  

What happens if these various bear markets strike while the client is taking ongoing withdrawals from the portfolio?

How do the results change?

Taking the same portfolios and assuming that there is an annual withdrawal of $50,000 at the end of the year which increases annually, assuming 3 per cent inflation, the results alter substantially:  

1. The steady return portfolio grows to $1,800,000 by year 21.
2. The 1-year dip portfolio grows to around $1,700,000 by year 21.  
3. The 5-year dip portfolio falls far lower due to the withdrawals, and even after the recovery, finishes at just over $1,000,000.  
4. The 10-year dip portfolio with its tiny decline of only -1.5 per cent per year in returns is the catastrophe. It drops so low with ongoing withdrawals, that by the time the good returns return, the portfolio can’t recover. It actually runs out of money completely in year 21. (Refer to Figure 1.)  

So what does all of this mean?  

While we tend to focus on sharp market crashes, sudden declines that recover quickly within just a year or few are not necessarily problematic, whether it’s the crash of 1987 (which recovered all of its losses within about a year) or the financial crisis of 2008 (which recovered nearly all of its losses in just over two years).  

Rather than those black swan events that ultimately are just a short-term distraction, what is far more destructive to client portfolios are extended periods of merely mediocre returns, such as the entire decade from 2000 to 2010 (or from 1966 to 1976).

And notably, these results are not black swans.

The examples here are all simply minus two standard deviation events. These are scenarios that Monte Carlo analysis already models. We just don't tend to focus on them very much.

The bottom line is that when we talk about the impact of adverse markets and return sequencing on retired clients’ portfolios, the point is not the risk of short-term market volatility.

It’s the risk of extended periods of time that generate merely mediocre, below-average returns.

And as history (and even normal distributions) show, these events may be uncommon but they are not extremely rare, and they are certainly not black swans. They are risks that can be, and should be, planned for.

Michael Kitces is research director of Washington DC-based Pinnacle Advisory Group and will be a presenter at the PortfolioConstruction Forum Conference in August 2012.