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Big market drops happen more often than you think

(MoneyWatch) It seems like every crisis we experience in the markets is a "once-in-a-lifetime" crisis. Other common phrases are "unpredictable," "never seen before" and "unprecedented." When those statements come up, the most appropriate phrase would be "ignorant of financial history."

The stock market is soaring, and investors are jumping in. We saw yesterday that stock funds had net inflows of $27 billion in February, with stock exchange-traded funds seeing an additional $25 billion. March was experiencing more of the same.

That makes this a perfect time to remember that the market experiences crises on a regular basis. In fact, as the following table shows, we have had five periods when the U.S. stock market fell 50 percent or more in real terms.

In addition, looking at data going back to 1890, we have had another 12 periods when the market fell at least 20 percent in real terms, giving us a total of 17. That's about one episode every seven years.

And the U.S. isn't alone in experiencing severe bear markets. Since 1900 the U.K. market experienced nine declines of more than 20 percent in real terms, including one decline of 74 percent (April 1972-November 1974). Just since 1957, Japan's market has experienced six declines of more than 20 percent in real terms, including a real loss of 72 percent (December 1989-March 2003).

The reason for pointing out that large losses happen with more frequency than most investors believe isn't to make you so afraid to invest in stocks that you avoid them totally. Instead, it's to remind you that stocks are risky, and the "coast is never clear." In fact, the frequency with which stocks suffer large losses is the very reason why stocks have provided such high real returns over the long term -- investors demand a large risk premium to compensate them for taking the risks of severe declines.

It's my experience that the only way for investors to successfully weather severe bear markets is to have a plan that incorporates the virtual certainty that they will occur. That means having a plan that makes sure that you don't take more risk than you have the ability, willingness or need to take. It also means having an allocation to stocks that isn't so high that your stomach will reach its GMO point -- the point when it screams GET ME OUT -- if stocks drop.

Does your investment plan meet that test? Not having a well-developed plan and not knowing your investment history are sure-fire recipes to being doomed to repeating the same mistakes.

Image courtesy of Flickr user ericskiff.

Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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