Stocks-gone-wild describes the past couple of weeks in the market. Stocks have been rising for so long that it begs the question on so many minds, have we hit a market top? If we have, and if stock prices continue falling, are you prepared?
Review the chart below to see the returns needed to recover from different levels of losses in a portfolio. Then compare that to the potential portfolio returns from four scenarios of a portfolio split between stocks and bonds.
Examples: A $100,000 portfolio declines by 20% to $80,000 [$100,000 * (1-.20)] = $80,000. In order for that portfolio to return to a $100,000 it would need to have a return of 25%. [$80,000 * (1+.25) = $100,000]. If your portfolio dropped by 40% you would need a 67% return to get back to your initial investment.
For my fellow math geeks: Calculation for Return Needed to Recover is [(1/1+loss)-1]
| Portfolio Loss | Return Needed to Recover |
| -10% | 11% |
| -20% | 25% |
| -30% | 43% |
| -40% | 67% |
| -50% | 100% |
| -60% | 150% |
| -70% | 233% |
| -80% | 400% |
| -90% | 900% |
Diversified All Stock Portfolio
Bonds tend to protect the downside when stock prices fall. The chart below estimates portfolio returns under different scenarios during stock market declines. The stock returns move from negative 20% to a loss of 60%. Bonds assume a 3% return in each scenario.
| Allocation | Scenario 1 Stocks Lose 20% Bonds Return 3% | Scenario 2 Stocks Lose 40% Bonds Return 3% | Scenario 3 Stocks Lose 50% Bonds Return 3% | Scenario 4 Stocks Lose 60% Bonds Return 3% | |||||
| Stock | Bond | Portfolio Return | Portfolio Return | Portfolio Return | Portfolio Return | ||||
| 0% | 100% |
3.0% |
3.0% | 3.0% |
3.0% |
||||
| 20% | 80% |
-1.6% |
-5.6% | -7.6% |
-9.6% |
||||
| 40% | 60% |
-6.2% |
-14.2% | -18.2% |
-22.2% |
||||
| 50% | 50% |
-8.5% |
-18.5% | -23.5% |
-28.5% |
||||
| 60% | 40% |
-10.8% |
-22.8% | -28.8% |
-34.8% |
||||
| 80% | 20% |
-15.4% |
-31.4% | -39.4% |
-47.4% |
||||
| 100% | 0% |
-20.0% |
-40.0% | -50.0% |
-60.0% |
||||
A portfolio with all stocks would have no buffer during declines. As the portion invested in stocks decreases and bonds are added, downside risk is reduced. In Scenario 3, the 100 percent stock portfolio has a loss of 50 percent. If the portfolio has 50 percent in stock and 50 percent in bonds the portfolio loss could be reduced to -23.5 percent. The return needed to recover from a 50 percent loss is 100 percent. You would need about 31 percent portfolio return to recover from a 23.5% loss.
If you maintain a stock/bond allocation that considers your time horizon to goal(s), risk tolerance, and financial resources you will not get all the gains when stocks are rising but your portfolio value will have downside protection during a stock market decline, increasing the stability of a portfolio’s value. Maintaining a more stable value increases in importance as your financial goal get closer and there is less time available to recover from a severe market drop.