Equity markets returns have been very attractive historically, particularly over long horizons. However, the trade-off is that one is exposed to significant risk of losses.
The US markets have the longest and best statistics available and are also the largest equity markets, accounting for close to 60% of global capitalization weighted indices as of June 2023. They are a good place to start to get a sense of historical returns for equity. Investing is about making choices and so one should look at the returns on equity and other assets as well to make an informed choice. Table 1 shows the types of losses one should be prepared to withstand when one invests in equity.
History can give some context. Table 1 shows the 10 largest losses over a single day, a calendar month, a calendar day and most importantly the cumulative loss one would have endured from a peak level for the US market over the past 100 years.
Table 1: 10 largest losses on the S&P 500 for different periods
The largest drawdown loss was a very painful 86.2% for monthly data during the great depression. There were several other instances of large losses from 30% to 57%. An ameliorating factor is that if one continued to hold the equity index, historically one did recover value. The largest drawdown took 25 years to recover, though other instances of large losses recovered much more quickly.
Shown below are the largest drawdowns and recovery periods for the US, Japanese and Indian markets for the periods for which we have available data.
Table 2: 10 largest drawdowns on the S&P 500 Index and recovery periods
Table 3: 10 largest drawdowns on the Nikkei 225 Index and recovery periods
Table 4: 10 largest drawdowns on the Nifty 50 Index and recovery periods
Looking through these tables, one should get some sense of possible losses. When investing in a well-diversified portfolio of equities, one should be prepared that one has a loss of 30 to 50%. One cannot rule out the possibility of losses of 80% or even more. However, there is a large likelihood that if one continues to hold the positions, values recover over time.
Does this mean that equities do not have much risk if one is prepared to hold for long periods of time? The answer is no. Just because the markets came back historically, does not mean that they will recover fully from large losses in the future. Owners of equity are taking a risk and should be prepared for a permanent loss and the loss could be significant. However, given the historical experience – selling after a large loss may not be well advised. If one does take equity risk, it is worthwhile to plan to ride through large losses rather than sell when the pain is highest.
