Take a look at the following graphic, which is the year-by-year total return performance of the S&P 500 Index from 1987 – 2006:

Now imagine that you had invested \$10,000 at the beginning of 1987. NOTE: We are using the returns of the S&P 500 Index itself, which does not include any sort of managment expenses. By the end of 1999, your \$10,000 would have grown to \$86,108 giving you an annualized return of 18.01%:

The next three years wouldn’t have been as pleasant as you watched your account value drop back down to \$53,718 by the end of 2002, a decrease of 38.24% from the peak. OUCH!

It would then take over six years for the portfolio to get back up to the previous peak, which it finally did do sometime during 2006.

So, what’s my point(s) with all this?

1. Things tend to revert back to the mean. Since its creation in 1957*, the S&P 500 index has average around 10%. Although great at the time, returns in excess of 10% should be considered gravy and the investor should expect that over the long run, their rate of return is going to average 10%. The same can be said for down years.

2. After a losing year, it takes a greater rate of return to get you back where you started. In other words, if you lose 25% one year, you need a 33.33% return the next year just to get you back to where you were before. For example:

Say you have a \$100,000 and experience a 25% decline, leaving you with \$75,000. To get back to \$100,000, you need a return of 33.33%:

(\$100,000 ÷ \$75,000) – 1 = .3333 or 33.33%

Another way to look at is during the three declining years (2000 – 2002), the average loss was 14.55%. Over the next 3 years (2003 – 2005), the average gain was 14.39% and yet the portfolio was still worth \$5,699 LESS than it was at the end of 1999.

Interesting stuff, don’t you think? It’s amazing what you can learn when you look at the numbers.

*The Index dates back to 1923 but the index as we know it today (containing 500 companies) dates back to 1957.

### 11 responses to The Impact of a Couple of Bad Years!

1. Hah, what’s funny about this is those are exactly the years that I DID invest, except in addition to the major drops you mention, I had my investments cut in half by divorce…

2. This is why I am a fan of both dollar-cost averaging and dynamic balancing asset allocation strategies. With dollar cost averaging, I think the returns get smoothed out better. And with dynamic balancing between asset classes, it forces you to sell high and buy low – at least on a relative basis between asset classes. Hope that made sense (I know what I’m trying to say but not so sure I said it very well).

3. Of course, if you DCA instead of lump sum invest in an up year (and the market is up 66% of the time) then you’ll lose money.

Sadly, most of us have to DCA since we don’t have a lump sum.

4. jr,

There’s nothing wrong with DCA. I think it is a great asset allocation strategy. Those “gurus” who put it down, don’t know what they are talking about. And you’re right: MOST of us can’t invest any other way.

5. I haven’t heard much about dynamic balancing asset allocation. Can someone point me to a good tutorial?

6. @ Jonathon – I’m not sure where to point you for reading material. But, it’s pretty simple (and I’m probably using the wrong term anyhow). First of all, I subscribe to a theory that asset allocation is the primary driver of returns. And that said, I also believe in broad market diversification within asset classes – i.e. I don’t want any single portfolio manager to have a sizable impact.

The key with asset allocation strategies is that in order to maintain the target asset allocation, the portfolio has to be rebalanced on a frequent basis. Say purely as an example, you want 80% stocks and 20% bonds. If equities are doing well relative to bonds, then you might end up with 90% equities, 10% bonds. Therefore, in order to rebalance, some equites are sold in order to buy some bonds and bring the allocation mix back into balance. In this way, you are constantly selling high and buying low, at least on a relative basis. Of course, my portfolio mix is somewhat more sophisticated than simply stocks vs bonds, but I’m only illustrating the method.

The dynamic part is that with some funds (the one I use), this rebalancing happens on a regular basis without my having to do anything. Rather then use the word dynamic (which implies real time), I should have said automatic.

So, now I think you can see, it’s a pretty old concept.

7. This brings up an interesting topic – which is capital preservation is very important because any impairment in capital dealys your financial goals considerably. The indices underperformed massively after 2000 because they were overvalued.

Which brings the point to an interesting debate : Is index investing the end all and be all way because of its low cost? What are you exactly paying a fund manager for? Simply outperformance of index , or making sure he or she does not overpay for stocks? Bear in mind that many value fund managers have positive returns from 2000 to 2006.

I’m rambling on – but just some food for thought.

1. - January 27, 2007