We are not trying to increase our returns here—we probably will not—but to reduce our risk. Like a seat belt, these measures won’t eliminate either the possibility of crashes or the risks we take, but they will substantially improve our odds of achieving our goals, which is all we are looking for.
2008 Was Not A One-Time Event
We all remember the crash of 2008. It was not a one-time event. In fact, stock market crashes happen fairly regularly, so we need to plan for them like we would any other life event.
First, let’s look at 1987. You may be old enough to remember it. It remains the largest single-day percentage crash in the U.S. markets. The Dow Jones Industrial Average dropped more than 25 percent. How could we defend against a downturn like this?
A conventional portfolio, say 60-percent stocks and 40-percent bonds, would have been exposed to a 15-percent drop in one day simply from its exposure to stocks. As you may remember from our earlier risk discussions, a 15-percent drop would require a larger recovery—in this case, 20 percent—to break even. More to the point, for individuals who retired in 1987, their entire retirement plan could have been crippled for decades by that one-time event. Just like the Ford Pinto car, a “Pinto” portfolio can experience catastrophic results in a crash.
In 2000, when the dot-com boom turned to bust, the Nasdaq technology stock index dropped by more than 60 percent and the S&P 500 by more than 40 percent. Many investors were exposed to tech stocks, so if they held 60 percent in the Nasdaq, for example—and many held more—they would have experienced a 36-percent drop in the portfolio as a whole. Note that it took 15 years for the Nasdaq to recover and pass its previous high. Even for a conservative investor in the S&P 500, the loss would have been almost 15 percent. Imagine if you were a college student preparing to start your freshman year or a new retiree in 2000.
In 2008, the S&P 500 dropped more than 50 percent. Again, for the conventional portfolio with a 60-percent weighting in stocks, that’s a loss of more than 30 percent. As you can see, twice in the past 20 years—and three times in the past 30—the market has blown up in a way that could have destroyed the financial plans of many individuals, including retirees and college students.
These are scary numbers. They become even scarier when you consider that, in Wall Street terms, a 60/40 portfolio is moderately conservative. The target return on a portfolio like this is typically in the 8-percent range. Yet three times in the past 30 years, a moderately conservative portfolio has dropped between 15 percent and 30 percent.
This simply doesn’t have to be the case, as we will see. What the average investor needs is a portfolio that has been crash tested—one that has seat belts to minimize our risk of blowing up. This is our goal, and this is what we will discuss in the coming chapters.
Diversification With An Insurance Policy