During the most recent quarter, U.S. Stocks (as represented by the S&P 500) have hit another all-time high. After a decade of above average stock returns and fears of the last recession a distant memory, it’s hard not to wonder if we should invest in anything other than stocks. After all, as you can see below, they’ve done phenomenally well over the last 10 years, especially compared to Cash and U.S. Bonds:
To put this into perspective, $1,000,000 in stocks would have grown to $3,096,220 while bonds and cash would have grown to $1,448,236 and $1,030,000, respectively. This is eye-popping wealth creation that causes even the most disciplined investor in us to consider throwing caution to the wind and going all-in with stocks. Of course, seasoned investors know there is no reward without risk. The reason investors are compensated with higher long-term returns in stocks vs. bonds and cash is because stock investors must endure significant declines in the value of their portfolios every so often. The orange line in the chart below represents drawdowns (% drop from the previous high to the low) in the S&P 500 since 1976.
As you can see, stocks occasionally go through very uncomfortable declines. For instance, in the Great Recession of ’08-’09, stocks fell by more than 50%. In dollar terms, $1,000,000 in stocks would have dropped to $490,500. For comparison, the blue line in the chart represents drawdowns for U.S. Bonds, which was barely a blip during the same period. Drawdowns in bonds have historically been a fraction of what they’ve been in stocks. This safety, however, comes at a cost: lower long-term returns.
Withstanding one of these stock market drawdowns […]