Sunday, 4 October 2015

The Big Picture During Bear Markets

Bear markets can be very frightening. They can cause stocks to drop by 40% to 60% and stay there for a fairly long period of time. It can be quite stressful to go through a bear market, especially for young investors. However, it is helpful to look at the big picture, which is this: even though the prevailing bear market might look very frightening, most young investors are still working, and there are 20 to 30 years of income still to be earned. If you include these unearned income in your total wealth, you will find that the prevailing bear market actually only eats up a small fraction of your total wealth. Let us consider the following example.

Starting Salary  $      3,000
Annual Salary Growth 5%
Salary Ceiling  $    10,000
Investment Allocation 10%
Asset Returns 7%
Max. Drawdown 50%

A fresh graduate aged 25 is able to earn a starting salary of $3,000 per month. This salary grows at a rate of 5% annually. Let's further assume that his salary does not grow forever, and his salary ceiling is $10,000 per month. He is able to set aside 10% of his monthly salary for investment, which grows at a long-term average rate of 7% per year. During a bear market, he loses up to 50% of his invested capital in unrealised losses, which can be quite painful for a young investor.

At the age of 30, 5 years after working, he would have accumulated an investment capital of $22,729, comprising the $300 he set aside every month which grows at the long-term average rate of 7% per year. At the depth of the bear market, he would have lost 50% or $11,364 of his investment capital that he has so painstakingly built up over the last 5 years. Although the losses are significant, he still has 35 years of working life in front of him. Assuming that he continues to set aside 10% of his future monthly salary for investment, he would have an unearned present-value capital of $100,457 (discounted using the 7% long-term annualised asset return), or 4.4 times his earned capital. The unrealised losses just make up 9% of his total wealth, which is a lot more comfortable than the 50% unrealised losses. The figure below shows the amount of earned capital and unearned capital at age of 30, 35, 40 and 45 for the same person.

Total Capital for Different Age Group

As the person increases in age, his unearned capital will reduce as it is progressively transformed into earned capital. At age 35, the unearned capital is still 65% of his total capital, which is equivalent to 1.8 times of his earned capital. The unrealised losses just make up 17% of his total wealth. At age 40, the unearned capital is 50% of his total capital and the unrealised losses make up 25% of the total wealth. Only after the age of 40 would the unearned capital fall below 50% of the total capital and the unrealised losses make up a significant portion of the total wealth. By this time, he would need to take less risk to reduce the amount of potential losses.

The point is, if you are a young investor, the prevailing bear market might look very frightening as you sustain heavy losses in percentage terms. However, if you consider the big picture of future cashflows, the amount of unrealised losses is considerably smaller. I would even say that a few years after you have gone through this difficult period and accumulated more capital, you might look back at this period and realised that the "signficant" unrealised losses that caused so much pain is actually fairly insignificant. As an example, at the depth of the 2000-2003 bear market, my unrealised losses were $50,000, which was equivalent to 50% of my invested capital. It was a very significant loss and very depressing. But by the time I got to the depth of the Global Financial Crisis (GFC) 5 years later, the amount of unrealised loss was around $175,000 to $200,000. The $50,000 unrealised loss sustained during the 2000-2003 bear market that seemed so significant then had paled in comparison. You might not believe me now as you go through his difficult period, but in a few years' time, you will realise that this is true. What is important now is not how much money you have lost, but how many lessons have you gained in investing, so that in a few years' time, as your investment capital grows, you will not make similar mistakes again, which are going to cost you a lot more since your investment capital has increased.

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  1. Nice article.
    We should take a long-term view on our investments. Bear markets do not last long.

    1. Yes, agree that we should take a long-term view on our investments.

  2. It is damn shitty seeing losses of 5 digits and 6 digits. but this is an article on framing. i hope more people read this and try to understand what you meant.

    1. The profit-and-loss statement always takes attention. If we can ignore it, we can make better investment decisions.

  3. Awesome post! I'm 21 and although I haven't gone through a major event like GFC, I totally agree with you on losses becomes pale in comparison especially since our capital base is still small. Learn as much as we can now so that we won't commit the same silly mistakes when our capital base is larger. Same lesson, different price!

    Thanks for the reminder!

  4. Hi BI,

    nice article and good reminder. I always believed losses are part and parcel of investing and having someone telling it as it is through the 2000s is assuring.

    Not sure if I have the "balls" to go through the bear as calmly as u said it. Although I started investing in the late 2000s I never had so much skin in the game as I am

    To see the loss balloon bigger and bigger and then the return exceeding it finally is a true rite of passage for anyone claiming to be a long term investor.

    Hope I survive the next bear

    1. Hi SI,

      Yes, losses are part and parcel of investing. They happen to any investor, whether young or experienced. But with the right expectations, composure and cash-on-hand, any investor will survive and even thrive in the bear market. I'm sure you will too!