02 Jul COTW: U.S. Bull & Bear Market Cycles
The chart below can be downloaded here.
For this week’s chart we updated one that has made the rounds dozens of times over the years: a long-term comparison of the cumulative returns of bull and bear markets in U.S. stocks. Our update fixes an issue we have with a version of this chart that compares the linear percentage gains in bull markets with the losses in bear markets on the same axis as if they are comparable. They are not. For the chart and examples that follow we use daily price returns (i.e. excluding dividends and taxes).
Gains and losses of the same magnitude have a very different impact on a portfolio. A $100 investment that declines 50% and then increases 50% leaves you with $75 (a 25% loss). Similarly, an investment that gains 100% and then declines 50% is back to where it started (for a return of 0%). For instance, investors who suffered the 86% decline during the Great Depression didn’t recoup those losses after the market rose 86% from the bear market low – not even close. Those losses were only recouped 25 years later in 1954 after the market had advanced 625%. Gains expressed in percentages are apples and losses expressed the same way are oranges.
Using a logarithmic-scale on the return axis solves for this mathematical quirk, but it also makes the chart harder to interpret as it visually deemphasizes the impact of compounding. To try solve for this, we have adjusted the scale of the declines during bear markets to demonstrate the non-linear impact they have on portfolios. Instead of showing losses as the linear percentage decline, we express them as the inverse of the percentage gain necessary to recoup the loss. After our adjustment, gains and losses can now be visually compared on an apples-to-apples basis.
Bear markets and the risk of loss are features, not bugs, of the stock market. If you spend your life worrying about them you may be too afraid to invest at all, but if you pretend they aren’t a big deal and fail to understand how damaging they can be, you may not respect the value of risk management and diversification when you need them most.
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