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If you invest in risk assets like stocks, you’re bound to face drawdowns. After all, they’re merely the price you pay in exchange for the chance of higher returns. But knowledge of this fact alone hardly makes big drawdowns any less discomfiting. So, how do you dig your way out?
Luckily, the market does most of the digging for you, most of the time. Market corrections — peak-to-trough declines of more than 10% but less than 20% — occur roughly once every year or two.
In these instances, recoveries are often swift. Investors holding broad-market index funds, like Vanguard’s Total Stock Market Index Fund ETF (NYSEMKT: VTI), can expect to see new all-time highs within an average of four months.
Even bear markets — peak-to-trough declines of 20% or more — are accompanied by reasonably quick bounce backs. On average, the S&P 500 fully recovers from its bear markets within 24 months.
It’s only when steep recessions crater the market that recovery periods become long and painful. However, even the worst of drawdowns don’t last forever.
Image source: Getty Images.
The perils of large drawdowns
The first decade of the 21st century was not exactly a pleasant time for the U.S. stock market. The dot-com crash of 2000 to 2002 was followed in quick succession by the Global Financial Crisis, which roiled equity markets from 2007 to 2009.
Image source: Koyfin. Annotations by author.
Investors who survived this “lost decade” — the 10-year period from 2000 to 2010 marked by zero returns — would find the era’s solemn lessons on the dangers of large, unmitigated drawdowns to be difficult to forget.
At the same time, the aughts became a reminder of the difficult and prolonged — but nonetheless far from impossible — recoveries that needed to follow to reach new all-time highs.
Specifically, as losses mount, it becomes more difficult to make your money back. For instance, while breaking even from a 10% loss requires an 11.1% gain, recovering from a 20% drawdown requires a 25% gain.
As drawdowns get steeper, the gains required to break even balloon in size. To break even from a 50% loss, you’ll need to double your portfolio from the bottom. Lose 75% of your bankroll, and you’ll need to make 300% in order to break even.
This simple yet sobering reality means that the gain required to break even from a loss (of any size) is always larger than the loss itself. Put another way, drawdowns that deepen by every additional 1% require a subsequent gain of more than 1% to achieve break even.
As a result, very substantial losses become nearly insurmountable — but only nearly.
Image source: Author’s calculations in Microsoft Excel.
Hope is not lost
However, as difficult as this decade was, it also taught investors another lesson — the opposite one, in fact.
In spite of these grievous losses and steep odds, the U.S. stock market has managed to soar to new all-time highs — each and every single time.
This even includes the seemingly fatal 89% peak-to-trough drawdown the Dow sustained during the Great Depression bear market of 1929 to 1932.
Though it took 25 years for the market to fully recover, the Dow today is nearly 100 times higher than its 1929 pre-crash peak — a tremendous testament to both the remarkable resilience of the American stock market — and to the protective power of a long-term, buy-and-hold strategy.
After all, stock markets tend to trend up over long periods of time. If you take care to avoid losses that have the potential to wipe your portfolio out — for example, by staying prudently invested in a series of well-diversified broad-market index funds and resisting the urge to panic sell even in the throes of a bear market — you’ll likely get to stay in the game.
And while deceptively simple, that’s all you really need to do. Thanks to the power of compounding, average returns earned over above-average periods of time lead to extraordinary results.
That’s how U.S. markets staged their comeback after suffering the greatest loss in stock market history. And it’s how you’ll earn your money back — and then some, too.
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Fool contributor Ryan Sze owns shares of VTI. The Motley Fool owns and recommends Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.
