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Q4 2023 Market Commentary

January 17, 2024

Reviewing A Math Lesson IRL (In Real Life)

by Timothy J. Videnka, CFA, CFP®

“Obvious’ is the most dangerous word in Mathematics.” – Eric T. Bell, Mathematician

Historically, the stock market has gone up approximately 70% of the time, in calendar year terms. During periods when it has not risen, there have been some major reductions in value. But time has a way of changing the perceived impact of these drops, as they often get reduced to small dips on a long-term historical chart of the Dow Jones Industrial Average or the S&P 500. Having been in the financial markets since the late 1990s, we can affirm that the experience in real time was much more painful than what the long-term chart might indicate. The bear markets of the early 2000s and 2007-early 2009 both had nearly 50% drops in value, from peak to trough. For many investors, the direct impact was a delayed retirement or a substantially altered lifestyle in retirement, including the dreaded scenario of having to go back to work. More recently, in calendar year 2022, the S&P 500 experienced a peak-to-trough drop of 25% in price terms. It has rallied nearly 33% from its 2022 low and has yet to establish a new all-time high. The result has been negative price performance over the two-year period from January 1, 2022 to December 31, 2023. How can this be when 33% is greater than 25%?


The Other Side: Downside Risk

I can recall early in my journey obtaining the Chartered Financial Analyst (CFA) designation an explanation of the math regarding return calculations. This discussion included not only the different ways to calculate returns but also the strong gains needed to recover lost portfolio value. To the casual observer, the only way to grow a portfolio is for asset prices to go up. For the buy and hold investor, this is a correct observation; however, it glosses over the complexity inherent in the damage that a bear market can inflict. As noted above, bear markets often get reduced to small dips on long-term historical charts. The chart below attempts to illustrate the hidden nefarious nature of those small dips.


What this table demonstrates is that any drop in value requires a larger percentage gain to recoup the starting value. The real eye-openers start when a portfolio loses 25% of its value, which requires 33% to get back to even. A 50% loss requires a 100% gain to recapture the starting value.

The Order: Sequence Matters When You Are Accumulating or Distributing

To delve deeper into the hidden dangers of having full downside participation, we will show what happens when there is a bear market at the beginning of a sequence versus at the end, and evaluate the differences when spending is included. In the table below, scenarios A & B have a starting value of $100,000 and no spending; scenario B’s yearly returns are the inverse of scenario A, yet they both end with the same dollar value. So the difference in the annual returns sequence has no impact on the outcome, absent any annual deposits or withdrawals.

Now let’s introduce some spending to see how that impacts the end results while keeping the original sequence of returns the same. Our experience tells us that most of the investing public are in either accumulation or distribution stages. That is, they are either adding to their portfolio or they are spending it down. See table below assuming a 5% withdrawal rate.

The impact of a $5,000 per year spend has scenario B come in 12.6% below scenario A. That equates to a difference of $11,775, or 2.4 years of less spending. Clearly, when there is spending involved the sequence of the returns becomes very important. The above section was taken from Forbes:


What may not be obvious regarding a portfolio is that if full downside participation can be avoided, then you aren’t forced to work as hard to regain the original value. This becomes even more critical when a portfolio is being added to or being spent down. In our view, managing the downside risk is key to portfolio longevity.