Monday, February 27, 2023

What’s so hard about investing in the stock market?

One of the hardest things about investing for most people to understand is the math of gains and losses.  For example, a 50% gain just will not allow a portfolio to recover from a 50% loss.  Rather the portfolio will need a 100% gain to offset the 50% loss.

Many investors use the S&P 500 as a measuring stick to monitor the returns of their portfolio.  In other words, are they doing better or worse, than the general market?  On January 2, 2020 the S&P 500 opened at 3,244.67.  This was the year COVID-19 raised its ugly head.  In just a few months, by 03/23/2020 the S&P closed at 2,237.40.  This means that in a period of a little more than 2-1/2 months the market performance as measured by the S&P 500 was down by 1,007.27 points or 31.04%.

To get back to even the market would have to climb a total of 45.012% in value.  It did … but it took a total of 4 months to do it.  Yes, by 07/20/2020 the S&P 500 was back up to an opening price of 3,251.84 (just above where it opened at the beginning of the year).  It took 2.5 months to fall and 4 months to recover.  This should tell you something.

By December 31, 2020 the S&P 500 closed at 3,733.27 – so for the year (because of the covid decline) it only gained 488.60 points or 15.06%.  Still, that is not bad. 

Let’s look at the next year.  On December 31, 2020 the S&P 500 closed at 3,733.27 and went up for most of the year (with the exception of a few declines that did not amount to much).  The index closed on December 31, 2022 at 4,772.49 – which equates to a gain of 1039.22 or 27.83%.

Take a look at this chart for this period in time:

So as you can see, over the period of two years a person investing in the S&P 500 index would have had a return of 15.06% + 27.83% or 42.89%.  If your investments are not doing this good … perhaps selling everything and buying the Exchange Traded Fund (SPY), which tracks the S&P 500 index, would be the way to go.  Here is how it looked over the two years mentioned.

This fund increased in value from $324.87 on January 2, 2020 to $474.96 by the end of 2021;  An increase of $150.09 per share or 46.20%.  In addition, it pays dividends every three months and the current dividend payout is $5.66 per share per quarter or $22.64 per share per year.

Then we had 2022:

On December 31, 2021 the S&P 500 Index was valued at 4,766.10 at the close of trading and by the end of the year (12/30/2022) the index had a closing value of just 3,839.50.  So, a person, if their portfolio was keeping pace with the S&P 500 would have lost 19.441% in value during the 2022 calendar year.

This means a $10,000 portfolio at the beginning of the year, was worth $8,055.90 at the end of the year … Or a $100,000 portfolio at the beginning of the year, was worth $80,559 by the end of the year.

For a person to break-even by the end of 2023 their portfolio would have to gain no less than 24.069%.  As we saw from the year 2022, this is doable.  However, it is not as likely as you may think. 

Going to my favorite robot – the Artificial Intelligence known as ChatGPT and asking this question:  How many times over the past 40 years has the S&P 500 gained greater than 24% in a year?  This is the response – and we must remember ChatGPT has only been trained through 2021 on most things.

Since the S&P 500 has gained greater than 24% in a year several times over the past 40 years, here’s a list of the years when this occurred:

1. 1983: The S&P 500 gained 26.33%.
2. 1985: The S&P 500 gained 26.33%.
3. 1989: The S&P 500 gained 27.25%.
4. 1995: The S&P 500 gained 34.11%.
5. 1997: The S&P 500 gained 33.36%.
6. 1998: The S&P 500 gained 28.58%.
7. 2013: The S&P 500 gained 29.60%.
8. 2019: The S&P 500 gained 28.88%.

Therefore, over the past 40 years, there have been a total of 8 years where the S&P 500 gained greater than 24% in a year.  If we include 2021 that would be 9 years out of 40 or about 22.5% of the time.

But what if your portfolio lost more than 19.441% in value last year?  Well to help you I found this short article by, Craig L. Israelsen, Ph.D., on the internet:  http://shurwest.com/wp-content/uploads/2013/08/The-Math-of-Gains-Losses.pdf.

Here is a table that was found in the above article:

As you can see, if you lose 50% in value you will need 100% to get back to even … and if you lose an additional 10% (say 60% in value) you will need an additional 50% (a total of 150%) to get back to even. The more you lose the greater you need to gain to get back to even.

To expand the table just a little … if a person is down 80%, they will need a 400% return to break-even and if they are down as much as 90%, they will need a 900% gain to get back to even.  This may help you understand why the fall down is a whole lot faster than the climb back up.

As the article states … it is a long and winding road to recovery.  If your portfolio were down a mere 35% in 2022 – you will need a return of 54% just to get back to even. The stock market has not had a 54% return in any recent year, at least since 1970 (53 years by the end of this year).  Therefore, you can probably guess that it is going to take more than one year to recover from a 35% loss in the stock market – unless we have another year like 1933.

The highest return year ever in the stock market based on the S&P 500 index was in 1933, during the Great Depression, when the index gained an astounding 66.8%.

It’s worth noting, however, that the market environment during 1933 was vastly different from what we see today. The U.S. was in the midst of an economic crisis, and the stock market had experienced significant declines in the preceding years. The high return in 1933 was largely due to a recovery from the extreme lows of the prior years.

In more recent times, the highest return year in the stock market was in 1954, when the S&P 500 index gained 52.6%. In the past few decades, the highest return years have been in the range of 20-30%, with 1995 and 2013 being the highest at 34.1% and 29.6%, respectively.

Going back to my favorite robot I asked this question:

What have been stock market returns on a yearly basis for the past 20 years?

And here’s the answer I got:

Year | S&P 500 Return (%)

2021 | 26.95

2020 | 16.26

2019 | 31.49

2018 | -4.38

2017 | 21.83

2016 | 11.96

2015 | 1.38

2014 | 13.69

2013 | 29.60

2012 | 16.00

2011 | 2.11

2010 | 15.06

2009 | 26.46

2008 | -37.00

2007 | 5.49

2006 | 15.79

2005 | 4.91

2004 | 10.74

2003 | 28.68

2002 | -22.10

Now what you see is 20 years of returns.  Notice how there are only three years that show negative (red) numbers.  I’ve told my readers time and time again that the market does not concern me because I understand that it is up about 75% of the time.  In the past 20 years it has been down 3 years (15% of the time) and up 17 years (85% of the time).  Long-term though (more than 20 years) you can count on that 67% to 75% of the time the market will be up.  Being able to count on it is not guarantee of it.

However, this is what you have to pay attention too.  My next question for the Robot:

What has been the average stock market return each year over the past 20 years?

It’s answer:

To calculate the average stock market return each year over the past 20 years (2002-2021), we can add up the annual returns of the S&P 500 index and divide by the number of years:

(26.95 + 16.26 + 31.49 – 4.38 + 21.83 + 11.96 + 1.38 + 13.69 + 29.60 + 16.00 + 2.11 + 15.06 + 26.46 – 37.00 + 5.49 + 15.79 + 4.91 + 10.74 + 28.68 – 22.10) / 20 = 7.48%.

As you read this it is important to remember that past performance is not necessarily indicative of future results.

Now that you know how much you need to gain to get back to even when you’ve taken a loss (or at least how to calculate it) – here’s the formula … [1/(1-loss amount as decimal)]-1 X100 = return needed … the rest is up to you. 

1. Do you by more of the stock while it’s at a discount and reduce the amount you need to gain to break even, or
2. Do you cut your losses and look for other alternatives?

Only you can answer those questions and a lot of those answers will be based on your very own risk tolerance.

Risk Tolerance:

Monitoring your risk tolerance is an important aspect of investing as it helps you make investment decisions that are aligned with your financial goals and personal comfort level with risk. Here are some ways to monitor your risk tolerance when it comes to investing:

1. Determine your investment goals: The first step is to define your investment goals, such as retirement, buying a home, or saving for your children’s education. Your investment goals will help you determine your investment horizon and risk tolerance.
2. Understand your risk tolerance: You can assess your risk tolerance by asking yourself questions about your investment preferences, such as how much money you can afford to lose, how comfortable you are with market fluctuations, and how much time you have to reach your investment goals.
3. Take a risk tolerance questionnaire: You can take a risk tolerance questionnaire, which is designed to measure your risk tolerance and help you determine how much risk you are willing to take with your investments. If you don’t have an advisor you can find many risk tolerance questionnaires on-line.
4. Monitor your emotional reactions: Pay attention to your emotional reactions to market fluctuations and changes in your investment portfolio. If you find yourself constantly worrying about your investments or feeling anxious about market volatility, it may be a sign that you need to adjust your investment strategy to better align with your risk tolerance.  You really need to be able to get a good night’s sleep regardless of how your investments are performing.
5. Consult with a financial advisor: If you are unsure about your risk tolerance or how to manage your investments, you may want to consult with a financial advisor who can help you develop an investment strategy that is tailored to your financial goals and risk tolerance.

Remember that your risk tolerance may change over time based on your personal circumstances and investment goals, so it’s important to regularly monitor and adjust your investment strategy as needed.

When you meet with the financial advisor ask him to provide a risk tolerance questionnaire to you, or at least answer the questions below and provide it to the financial advisor so that he or she can better assist you:

1. What is your investment goal (expect the time frame to be different with different goals and objectives)?

a. Short-term (1-2 years)

b. Medium-term (3-5 years)

c. Long-term (more than 5 years)

2.  How much money are you willing to lose in a worst-case scenario?

a. Less than 10% of my investment

b. 10-20% of my investment

c. More than 20% of my investment

3.  How would you describe your investment knowledge?

a. Limited

b. Moderate

c. Advanced

4.  How comfortable are you with market fluctuations?

a. Not at all comfortable

b. Somewhat comfortable

c. Very comfortable

5.  How important is liquidity to you?

a. Very important

b. Somewhat important

c. Not important

6.  How would you react to a significant market downturn?

a. Sell my investments and move to cash

b. Hold my investments and wait for the market to recover

c. Buy more investments while they are at a lower price

7.  What is your investment time horizon?

a. Less than 3 years

b. 3-5 years

c. More than 5 years

8.  How important is the potential for high returns to you?

a. Very important

b. Somewhat important

c. Not important

9.  How much investment risk are you willing to take?

a. Low risk with lower potential returns

b. Moderate risk with moderate potential returns

c. High risk with higher potential returns

10.  How important is capital preservation to you?

a. Very important

b. Somewhat important

c. Not important

Keep in mind that this is just a sample questionnaire, and there are many other factors that can influence your risk tolerance. It’s also important to note that the results of a risk tolerance questionnaire are just one factor to consider when making investment decisions, and it’s important to consult with a financial advisor to develop an investment strategy that is tailored to your individual needs and goals, especially if you don’t have any investment experience to learn from.

I hope this has been helpful.  If you have questions or comments let me know in the comment section and I will get back to you.

Good Investing,

Jerry Nix | FreeWaveMaker, LLC