2008: The bear growled and investors howled

Update to Chapter 12 of Ross, Westerfield, and Jordan’s

Fundamentals of Corporate Finance, 9/e (McGraw-Hill: 2010)

February 6, 2009

Bradford D. Jordan

2008: The bear growled and investors howled

2008 entered the record books as one of the worst years for stock market investors in US history. How bad was it? The widely followed S&P 500 index, which tracks the total market value of 500 of the largest US corporations, plunged 37 percent for the year. Of the 500 stocks in the index, 485 were down for the year.

Over the period 1926 – 2008, only the year 1931 had a lower return than 2008 (-43 percent versus -37 percent). Making matters worse, the downdraft continued with a further decline of 8.43 percent in January of 2009. In all, from November of 2007 (when the decline began) through January of 2009 (the last month available as this is written), the S&P 500 lost 45 percent of its value.

Figure 1 shows the month-by-month performance of the S&P 500 during 2008. As indicated, returns were negative in eight of the twelve months. Most of the damage occurred in the fall, with investors losing almost 17 percent in October alone. Small stocks fared no better. They also fell 37 percent for the year (with a 21 percent drop in October), their worst performance since losing 58 percent in 1937.

As Figure 1 suggests, stock prices were highly volatile during the year. Oddly, the S&P had 126 up days and 126 down days (remember the markets are closed weekends and holidays). Of course, the down days were much worse on average. To see how extraordinary volatility was in 2008, consider that there were 18 days during which the value of the S&P changed by more than five percent. There were 17 such moves between 1956 and 2007!

The drop in stock prices was a global phenomenon, and many of the world’s major markets were off by much more than the S&P. China, India, and Russia, for example, all experienced declines of more than 50 percent. Tiny Iceland saw share prices drop by more than 90 percent for the year. Trading on the Icelandic exchange was temporarily suspended on October 9. In what has to be a modern record for a single day, stocks fell by 76 percent when trading resumed on October 14.

Were there any bright spots for US investors? The answer is yes because, as stocks tanked, bonds soared, particularly US Treasury bonds. In fact, long-term Treasuries gained 26 percent, while shorter term Treasury bonds were up 13 percent. Long-term corporate bonds did less well, but still managed to finish in positive territory, up 9 percent. These returns were especially impressive considering that the rate of inflation, as measured by the CPI, was essentially zero.

What lessons should investors take away from this very recent bit of capital market history? First, and most obviously, stocks have significant risk! But there is a second, equally important lesson. Depending on the mix, a diversified portfolio of stocks and bonds probably would have suffered in 2008, but the losses would have been much smaller than those experienced by an all-stock portfolio. In other words, diversification matters.

Questions

  1. A dollar invested in large-company stocks (with all dividends reinvested) at the beginning of 1926 grew to $2,049.45 by the end of 2008 (compared to $3,252.98 at the end of 2007). What is the geometric average return for the period 1926-2008?
  2. Over the period 1926-2008, the arithmetic average return on large-company stocks was 11.7 percent with a standard deviation of 20.6 percent. Based on these numbers, and assuming a normal distribution for stock returns, how likely is a loss of 37 percent or more in a year (hint: you’ll need a z-table or, much easier, the NORMDIST function in Excel)?

Answers

  1. 2,049.451/83-1 = .096, or 9.6%.
  2. NORMDIST(-37, 11.7,20.6,1) = .009, or about 1% (or once a century).

Topic for Discussion

Q.Financial economists have known for some time that the normal distribution is only an approximation for stock returns. Relative to the normal distribution, stock returns have fatter tails, so extreme outcomes (in either direction) are somewhat more likely than the bell curve would suggest. For example, on October 19, 1987, stocks lost over 20 percent in a single day. Assuming a normal distribution, such a single day loss is probably so unlikely that it would not have occurred in the entire history of the universe. What are the implications for investors?

A.The primary implication is that stocks are more volatile than the bell curve suggests, and investors should be aware that large down (and up) years will occur more often. Diversifying into less volatile investments is probably wise, particularly for investors with relatively short time horizons. What about investors with long horizons such as undergraduate finance students? Here there is great controversy. One mechanical rule of thumb is to subtract an investor’s age from 100 (or 110) and use the answer as the stock allocation. However, such a rule obviously ignores differences in risk tolerance across investors.

A bigger issue concerns the behavior of individual investors in the face of market volatility. As Ben Graham noted, “The investor’s chief problem, and even his worst enemy, is likely to be himself.” Investors tend to take money out of stocks after they have declined and venture back in only after prices have risen. They also chase past returns, trade too much, and pay too much in fees. In other words, they guarantee themselves that they will bear the risk of losing money, but they forego much of the potential gain through bad market timing and excess expenses.

So how much should investors with long horizons allocate to stocks? There is no one-size-fits-all recommendation. Ben Graham suggests no more than 75 percent (and no less than 25 percent). Our answer is that that optimal allocation is the percentage that (1) lets you sleep at night and (2) is the maximum that leaves you completely confident that you will never sell following a decline.