Stock market long term risks

Question

This question has been spurred by the following question which was on the 'Hot Network Questions' Is it a lie that you can easily make money passively in the stock market? . The answers to that question made it clear that it is in fact worthwhile to invest in the stock market.

However, the proofs brought there seem to concentrate on the math of (relatively) short term numbers. But what about the long term risks of several decades? Assume someone invests in the stock market from age 20 till age 80. What are the chances that they don't lose everything most of the investment in a short time like in the great depression, even once, which might more than balance out the gains. Making money 99% of the time might still be offset by that one time it was all wiped out.

I'm assuming someone that is not an expert (who might know in advance when to quit by "reading" the market).

Answer 1

Look at the complete 90-year history of annual S&P 500 returns. The worst year in history is 1931, which was down 47% during the heart of the great depression. In the last 40 years, the market has only been down 9 years (<25%) and each down year was completely (or mostly) recovered within 2 years, followed by multiple years of growth.

Also, those returns do not include dividends. I don't have a good source right now, but if you reinvest dividends, the returns grow even more.

So the odds of losing even half of your investment in the stock market (using whatever period you choose to measure) is very low. Yes you'll have years where you lose 10, 20, even 30% of your portfolio, but historically those losses have been recovered in a few years (not counting the great depression 90 years ago, which took about 5 years when you include deflation and dividends).

Answer 2

Your concern may rightly stem from anecdotes provided by people who have lost their initial investments (and possibly more) "and will never touch the market again". How can that be, how can one lose more money than one invests?

People who have been burned by this are those that see the market as a way to make a quick buck. They use margin (borrowing money) to speculate on short term moves in the market. Typically, for a time, a few small trades go well and the speculator increase the amounts and frequency of the trades. Perhaps a few more go well, but then one goes sour and wipes out all profits made from the start. Many then attempt to win back their losses, which leads to only more losses. Given that they are playing with borrowed money, they may have to pay back more than they invested. The bottom line is: No one can accurately predict the short term moves of the market.

People who do well in the market, are those that have a long time horizon. They are investing with money that will not be needed in the next 5 years or so. Sure the investments may decrease in value, but provided they do not withdraw, generally speaking, they will return to profitability in relatively short order.

That holds true of the broader market, surely individual companies can lose value, and never regain, which is why it is suggested for small investors to purchase mutual fund which are a collection of people buying a collection of stocks.

Are there risks? Sure, but what do you think US business is going to do in the next 20 years? Look what they have done in the last 20 years. Sure stock prices will go down in the future, but they will also go up, and they will probably be much higher than today.

Answer 3

I think the "past history" explanations are good enough for the large parts, as other answers have covered - i.e., no index has ever lost all of its value or even as much as half of its value in a crash, and all of them have recovered in a medium time frame at worst.

However, from a more theoretical perspective (but still fairly basic), it's important to understand the difference between investing in a company and investing in the market.

Investing in a company, say, buying AMZN or AAPL or MSFT, is effectively betting that a company will continue to grow, or at least continue to produce similar value (particularly if it pays a dividend). It involves risk, though, and it's entirely possible that any one of these stocks might be at or near its all-time-forver peak (and thus, any investment would be a poor one, again except for dividends of course). Any given company can take a turn for the worse, or even go under entirely.

Investing in the stock market as a whole though, as index funds do, means you're effectively investing in the American economy (and even larger than that, since we have plenty of global companies). As the American economy grows, so does the stock market valuation. Since the index fund invests in, effectively, every American company, the performance of one or two isn't important. The performance of all of them is, in aggregate, so some failures are offset by the many successes, or even broadly by simply the general engine of the American economy.

And by grow, I don't just mean will continue to innovate (though I'm sure it will); even if we stagnated and just made what we make now, we're still constantly adding value. Ore in the ground has less value than steel has less value than machined pieces has less value than cars; even if the car company stops growing and just keeps making cars, the economy as a whole is still adding value to the starting state.

That's not to say you won't have dips; and it's of course possible that the American economy suddenly collapses and never recovers. But that situation is unlikely outside of a nuclear war or similar catastrophe; even in the case that the American economy permanently slows down, you're much more likely to just see our market perform more similarly to other countries' markets, which are slower than the US's market (5% instead of 7%, say). So long as we are still making things and people are still buying them, we still have net value being produced by the economy, and the stock market will collect that net value.

Answer 4

One way to answer this question is to consider the historical experience. Robert Shiller's website contains US stock market data from 1871 to the present day, a 147-year history which I have used to calculate the average, worst-case and best-case scenarios for investments of varying length. I also compute the chance of loss (the probability that the investment has a negative return over the period).

In all scenarios below, I consider investments initiated on January 1st and held for N years until December 31st. I assume that dividends are reinvested, and report the annualized return for the period.

| Number of Years | Worst Case | Best Case | Chance of Loss |
| 1               | -41.8%     |  54.4%    | 25.5%          |
| 3               | -26.7%     |  31.1%    | 14.2%          |
| 5               | -12.2%     |  28.4%    |  9.9%          |
| 10              | - 1.4%     |  19.5%    |  2.1%          |
| 20              |   3.4%     |  17.6%    |    0%          |
| 50              |   5.6%     |  13.4%    |    0%

Over the period the average annualized return is 9.12% but the experience varies widely. Over a ten year investment horizon there is nearly a 10% chance of realizing a negative return - but on the bright side, the worst-case return over ten years was 1.4% annually, a loss of around 15% over the period. Over any fifty-year investment horizon, an investor in the US stock market has never lost money, although picking a bad time to invest would result in only a 5.6% annualized return (although that is still 1,425% over the period).

Below I show a different view of the data - the annualized return for a 10 year and 40 year investment period, with different start dates. I think the picture here is quite hopeful - it shows that long-term returns (10 years plus) in the US stock market have been generally attractive.

We can also consider the drawdowns experienced, i.e. the percentage of portfolio value lost, as measured from the previous peak. This tells a stomach-churning story - the maximum peak-to-trough drawdown was over 80%, during the Great Depression. There have been two periods where the portfolio was down over 40% (the dot-com crash and the credit crisis) and several periods where it exceeded 30%.

So on this analysis, two well-known facts about the US stock market are confirmed -

1. The returns can be very attractive
2. The risks can be quite large
3. The risks diminish as you consider longer investment periods

Of course, this is not the end of the story. There are some major caveats, including

• I haven't discussed inflation, which can erode the real value of your investment even as its nominal value increases. As a rule of thumb, you can subtract 2% from the annualized returns above to account for inflation - though note that it can be much higher during specific periods.
• This is a backwards looking analysis, and obviously cannot capture any risks that have not occurred historically (an example of a Peso problem)
• The US is a huge outlier over the past 150 years, so only analysing the US will bias returns upwards and bias risk downwards. People who invested in the Argentinian stock market in the 1870s have much less to say about it today.
• Investors don't generally invest a chunk of money and forget about it. Typically they will top up their investment over time, which helps to mitigate the risk of early drawdowns (as you have plenty of time to top up the portfolio later).
• Most investors will rebalance their portfolio away from equities and into bonds as they near retirement, which reduces the risk of a large drawdown at the end of the investment period.
• Diversification can reduce risk, often without seriously hurting returns.
• Most investors have poor willpower and terrible market timing - they will eat into their investments to finance their lifestyle, the invest heavily ahead of market crashes and withdraw their investments just after crashes, when opportunities can be greatest.
• The discussion above ignores leverage. Although the risk of a significant drawdown (>50%) is low for an unleveraged investor, many investors use some form of leverage in their portfolio (e.g. they have a mortgage, and the combined value of their house and their investments is greater than their net worth). This is to say nothing of investors who buy stocks on margin, or invest via futures or other products that offer built-in leverage.

All of this goes to say that there is no simple answer to your question. Like any investment, a long-term investment in the stock market offers the potential for high returns, but also significant risks. You should take the same precautions as you would with any other investment -

• Do your due diligence
• Have a long-term horizon
• Don't risk more than you can afford to lose

Answer 5

A longer time frame gives you a smaller, not larger, chance of losing money. Although you have more chances to lose money, you also have more time to make the money back.

D Stanley's answer is good, but I think it would useful to add some more information about rolling stock market returns (rolling returns is when you pick some length of time x, and look at the return from t-x to t for all t). For example:

The worst one-year rolling time frame delivered a return of -43%.
...
If you were a long-term investor, the worst twenty years delivered a return of 6.4% a year.

So going by historical data, once you reach a 20 year time frame, the worst case scenario is that you get "only" a 6% return. There is of course some risk that the future won't follow historical trends, but the chance of losing money over 60 years is tiny.

Answer 6

The risk of a well diversified stock market investment is approximately the same as the risk of a large scale nuclear war.

Let me elaborate a bit. By owning a passively managed stock portfolio, you own a share of the world's economy. In the long term, it doesn't matter what the valuation is. Companies make profit and have to return the money they don't need to shareholders by buybacks or dividends.

If you gradually build up a well-diversified stock portfolio, you own a certain share of the world economy. What is the risk the investment loses its value? Approximately the same as the risk of world economy collapsing. I believe a large scale nuclear war is the worst risk, but there may be other risks as well, such as the risk of communism becoming widely adopted.

About the only thing you need to do in a 60-year investment is to stop reinvesting the dividends at the end, and perhaps gradually selling the investments if you don't want to leave an inheritance behind.

60 years is a long time! Your investment grows 33-fold, inflation-adjusted, taxes not subtracted, in this time (assumption: 8% return, 2% inflation). Valuation changes may mean it can be as low as 15-fold or as high as 65-fold.

If you invest 1000 USD once at age 20 and the dividend yield is 3% and dividend growth 5%, when you're 80 years old, you earn approximately 1000 USD per year (assuming dividends can be reinvested at approximately the same valuation)! Every single year after being 80 years old! This is adjusted for inflation and it's sustainable. Also, it grows at the same rate economy grows, i.e. at 4-5% nominal, 2-3% real rate. If you sell your investments, the amount per year could be even higher, but that depends on the valuation of the stock market at the time of being 80 years old. The dividends do not depend on the current valuation.

Based on this, it is foolish not to invest your extra money into the stock market.

Answer 7

I think you've been taking too many newspaper headlines as being true. They are written to be exciting and short, not accurate.

When the price of stock you hold goes down, you have not lost anything. If you owned 1% of a company the day before the stock plunge, you still own 1% of the company after the stock plunge.

You haven't lost any money until you sell a stock.

Your risk is not 'will there be a stock price plunge at some time between when I am 20 and when I am 80.'

Your risk is 'Will there be a stock price plunge going on when I need to sell my stock (to get money to live on because you have retired).

Assuming your investment is diversified enough (domestic share index, international share indexes, housing etc), then just sit through the dips (don't panic and sell). There will be good years that counter the bad.

Answer 8

This is why investments like pensions don't reckon on getting their money out of stocks at one optimal moment, but instead shift it out gradually over several years into lower-risk investments. This smooths out the effect of even a sudden drop. In fact a two-stage shift is common, first into corporate bonds then gilts, as a UK example (gilts are the U.K. equivalent of U.S. Treasury securities). The two stages would overlap and the whole shift would take 5 or even 10 years. This is automated in so-called lifestyle funds, so the individual doesn't have to worry about it, but it's often possible to choose a more active approach.

Answer 9

You are essentially asking us to give the probability of a Black Swan (https://en.wikipedia.org/wiki/The_Black_Swan:_The_Impact_of_the_Highly_Improbable) event like a revolution or nuclear war shutting down the stock market or making the economy collapse. Unfortunately events like that, which have only happened perhaps once before in history or have not happened yet at all, can't be assigned a probability in the normal sense. So we can't talk about the long term risk of the stock market.

Answer 10

It's a great question. But in a way it's only half a question.

I anticipated the 2008 crash. In fact this was something like the slowest car-crash in history: in 2007 banks were already having problems, people were talking about "sub-prime" stuff and derivatives.

So in 2008, before the real crisis struck, I converted all my investments into cash. I felt very smug in December 2008.

But this scared me off stock markets so much I didn't touch them for years afterwards.

Contrast this with the legendary Warren Buffet. In January 2009 he said "it's time to start buying again". The earnings people made from 2009 to 2016 or so have been epic, in most stable Western markets, at least. I wasn't one of them. Hindsight is a great thing: in January 2009 it seemed like the whole financial system was fragile as a spider's web.

What I learnt (finally! no longer smug)... is that what we really have to fear is an "L-shaped" crash. But there has never been such a thing. Even 1929 and 2008 were "V-shaped" crashes. Horrible, shattering to experience, especially for those who are speculating, rather than investing (as others have said).

As Warren Buffet himself has also said "our favourite holding time is forever". Drip-drip-drip over the years and try to avoid timing things: go for boring funds (e.g. tracker funds, with low charges on a low-charge investment platform). Invest and forget (with an active fund manager you have to keep an eye on whether they are still performing, and charges are much higher).

Answer 11

I am a researcher of the market and to answer your question you need to look at the data in a way that doesn't really seem to be presented here. The issue isn't gains or losses, but gains or losses relative to other opportunities. Imagine that I am 20 and invest $100,000 and at age 80 I have $100,000.01. I made a gain. That is the wrong discussion.

Let us start with a really poor outcome. Had you invested in the Dow Jones Industrial Average on January 1, 1929 and you had a fried invest in short-term Treasuries at the same time, you would not catch up to your friend until 1963 in total return, ignoring taxes and commissions. It could have been longer or shorter if the bond holder could have used certificates of deposit in lieu of bonds and if the holder of the Dow had minimal commissions, although they were regulated at the time and quite high.

Long cycles like this happen more often than people realize. I also ignored long-term bonds, real estate, non-precious metals, comic book, art and owning your own business.

The reason to buy stocks is that the dividends, but not the principal, are a good hedge against inflation. They tend to rise at the lagged inflation rate. The principal, however, is fickle. Bankruptcies and mergers become common over long periods of time in the sense that only one member of the original Dow still exists. However, of the remaining nineteen members only one went under and truly lost everything. The rest were either bought out at premiums or tetered on bankruptcy and were bought out at discounts. You would be very wealthy right now if you had purchased the original set of twenty stocks in that first list. You would not have as much money as the current average would imply, but you would have done quite well for yourself.

The reason to hold bonds is to protect yourself from bad times. Bonds are most valuable when things start falling apart. You especially want to hold bonds today if there is blood running in the street tomorrow. When people fly to safety they will pay huge premiums to protect their wealth by putting in bonds. Conversely, stocks are least valuable when you need them to be valuable and most valuable when they are not needed. Stocks are pro-cyclical and bonds are counter-cyclical. Bonds have poor inflation properties unless you happen to purchase them near the peak of an inflationary period, then the decision to buy will have been the best idea any human could have made. Of course nobody knows that peak, so you will be out of luck being that person.

The optimal investment tool is to use the Kelly Criterion. Unfortunately, the limitations of this forum in terms of mathematical notation limit the statement's helpfulness. If you have calculus then you can do the work for yourself. The Kelly Criterion will generate the greatest geometric profit of all gambling methods, regardless of what you are gambling on.

It was developed during the Cold War because the President launching nuclear weapons based on an electronically noisy signal which could be false is a devil of a gamble. There were several near launches during the Cold War that could have ended all life on Earth. The Kelly Criterion works independent of what you bet on.

Roughly, though, it protects you from gambling either too much or too little. In periods of low prices you will tend to hold more concentrated positions and in periods of high prices, like today, you will tend to hold many very small positions. If you have the calculus skills then you can make adjustments to the Criterion for life's constraints such as paying for a mortgage or a child's education. A person with a mortgage should carry smaller positions than the normal criterion suggests to assure payments on a mortgage even in times of crisis. Likewise, as the date of a college education approaches, then more bonds should be held.

If your long run concern is an income, then you should be buying stocks. If your long run concern is availability of emergency cash, then you should buy bonds. If you are going to be purely passive, then you should decide how to balance these constraints. You should also consider the relative value propositions of other potential assets, such as real estate, which I didn't really touch because its dynamics would take a long time. We have had forty years of falling inflation and that makes real estate very valuable, but we have also had large demographic and geographic shifts that need accounted for. It is a more complex discussion than your question seeks an answer for.

A final piece of advice. I had a colleague without much knowledge of the capital markets and she was invested entirely in stocks and was twenty-five. She had a terrible time opening her monthly statements because if it was down from the prior month it really shook her up. I asked her why she opened them. After all, if she isn't going to change her behavior, then the content of the statement doesn't matter. I recommended she look at them as one bunch to make sure the statements had proper crediting of contributions, but otherwise to not look at them. There I no need really if it will not alter your behavior.

If you are going to be a passive investor, read the statements as a way to verify compliance with the terms of the broker's agreement and matching up cash flows. Otherwise, it doesn't matter what they say. Make you plan and stick to it, for the next sixty years.