How risky is it to invest in equity index funds?

The S&P 500 had an approximate average annual return of 10% (before inflation) when measured from 1928-2016. This was the trigger that got me into index funds, the ability to put my savings to work for the long term, at low costs through a no non-sense approach supported by decades worth of data.

It is easy to look at those impressive historical returns and conclude that investing in the stock market is safe. But that isn’t the case – when you invest in equity index funds you are still exposed to (stock) market risks. Stocks are really volatile and expose you to shallow risk – potential capital losses which recover within a few years.

We don’t know how the future market declines will look like in terms of duration and severity. It is worth being aware of historical market declines so we can set proper expectations for future market declines.

Let’s take a look at historical bear markets. A bear market happens whenever there is a peak-to-trough (i.e. from peak to bottom) decline of 20% in the S&P 500 index. According to Moon Capital Management’s detailed analysis of U.S. Bear Markets there have been 11 bear markets since 1945:

When looking at bear markets it is important to pay attention to:

  • how long it lasted
  • the severity of the decline
  • how long it took for the market to recover to the previous peak.

The longest bear market (1946) lasted 36 months. The longest recovery took 65 months (after the 2007 bear market). The biggest S&P 500 decline, 57%, happened in the 2007 bear market.

There is a big difference between reading about bear markets and living through them. To quote Taylor Larimore in the Bogleheads forum:

Figures cannot convey the horrifying and debilitating effects of a bear market. You watch in agony as month after month your life savings evaporate before your eyes. Gloom and doom talk is everywhere. Nearly everyone else is selling. You have no idea when, or if, your portfolio will stop losing money.

Your friends and relatives urge you to sell. Nearly all financial experts recommend “sell”. You are ridiculed for trying to hold on. You begin to have self-doubt. Despair sets in. Buying stocks is unthinkable. Suicides increase.

That’s what a bear market is like.

To sail through these bear markets you need to have the discipline to “stay the course”. An honest assessment of your risk profile and a reasonable asset allocation will help you achieve that.