Ep7: Market Crisis and Portfolio Recovery Rates
March 1, 2019
About This Episode
In this episode, Patti and her Chief Planning Officer, Eric Fuhrman discuss the economic realities that determine how quickly or slowly portfolios will recover from this last market crisis. Patti will leave the listener with three actionable steps to implement during a market drawdown period to help aid in quicker portfolio recovery. These concrete steps provide a sound foundational reminder to help weather any market crisis.
Patti Brennan: Welcome to “The Patti Brennan Show.” Whether you have $20 or $20 million, this show is for those of you who want to protect, grow, and use your assets to live your very best life.
With me today is Eric Fuhrman, our chief planning officer. Today, we’re going to be talking about bear markets. We’ve just gone through a very painful period in the fourth quarter of 2018. We thought it would be really important to put it into perspective and talk about. Gee, when these times have happened historically, how long did it take to recover?
Eric, welcome to the show.
Eric Fuhrman: Patti, thank you so much. I have to be honest. These podcasts have become more of a regular thing. I literally stay up at nighttime just wondering what the next topic is that we’re going to be talking about and sharing with our audience.
I literally count the days between the time when you and I can come in studio again and talk about all of these very interesting things that we find fascinating and hope that our audience does, too.
Patti: You know, folks, he’s not kidding. I have received emails from Eric in the middle of the night and on weekends on various topics that he thought might be a good idea for us to talk about.
Eric: So true. My wife would verify that as well.
Patti: [laughs] Let’s talk about what just happened. Historically, when we think about it, we’re about to celebrate, if that’s a real thing, the 10th anniversary of the financial crisis. The scars of the financial crisis, they’re still with people today. It feels like it happened just yesterday.
When we were going through that awful drawdown period at the end of 2018, a number of people were worried and thinking we were going to have another experience like we had in the financial crisis.
Eric: That’s so right, Patti. It’s still just such an awareness and a heightened sensitivity to market volatility since that financial crisis for so many of our clients that lived through it. This topic is so timely because there’s a lot to unpack here.
The reality is that risk and return are inextricably linked. We can’t deny that. Over the long run, stocks are going to provide higher, long term returns than cash because the very existence of the capital markets depend on it. That’s why they’re there.
It’s important, imperative for anybody who desires to reap a return in excess of, say, a government Treasury bill. You have to accept that certainty is the enemy of growth.
Patti: Oh, Eric, very well said. That’s worth repeating. Certainty is the enemy of growth. Hey guys, I understand. We all want great returns. We all want that wonderful long term trajectory that you see on those mountain charts. If you look closely at those mountain charts again, there are periods of time those where markets also go down. They don’t go straight up.
Eric: Right, and you have to remember too that uncertainty is the very mechanism that makes those long term returns possible that allow people to help fund college, purchase that dream home, or retirement in so many cases. If anything, I would say you have to embrace uncertainty. Nobody likes these periods of time, but they’re a reality that we have to deal with.
Patti: It reminds me of when I was in the ICU. People go in for open heart surgery. Nobody wants to go in for the surgery, and it’s an uncomfortable period of time because it’s a really traumatic event in a person’s life. There’s so much focus on that patient when they’re in the ICU, and what is equally if not more important is that period of recovery.
Ultimately, how quickly that patient recovered had to do with how good of shape they were in before they had the surgery. It’s really important as we talk about this to keep in mind that how quickly you recover, the impact that it has on your financial life ultimately depends on the planning that you did going up to the bear market as part of your overall financial plan.
Eric: Normally I would like to avoid unnecessary comparisons between the financial industry and the medical field, but you can actually speak intelligently towards that as a former ICU nurse. Wouldn’t you say that the more acute that condition is, usually there’s a longer recovery period that comes along with that.
The more severe whatever the patient was going through, the longer you can expect the recovery to be, and you see that in the markets as well.
Patti: No question about it. If you go in for outpatient surgery, your recovery time could be in weeks. If you’re going for major major surgery, whether it be abdominal or heart or what have you, it could be six months or a year. It ultimately depends on many different factors. Again, nothing to be afraid of. At the end of it all, you’re going to have a healthy heart, you’re going to have better working legs or whatever it might be, but it’s painful to go through.
Eric: Listen, before we start unpacking all of this here in this relatively 15 to 20 minute session, why don’t we start with some definitions because in order to help the audience and the listeners out there truly understand what we’re talking about they need to have a good understanding of some very important definitions. Why don’t you go into that?
Patti: There’s three definitions that are important for you to understand. First is the drawdown period. That is the period from the tippy top peak of the portfolio down to the bottom, from peak to trough.
Eric: That’s basically the event.
Eric: The drawdown event, something that’s causing that.
Patti: Then there’s the recovery period. Once it hits that bottom, how long does it take to get from that bottom back up to where it was before the event occurred?
Eric: Or the highest statement that you got in the mail, how long does it take to get back to that point where we’re happy again?
Patti: The underwater period, which I think is real key, is the combination of both. From the beginning of the event, down to the bottom back up, that’s called the underwater period. We’re going to go through periods of time when we’ve had these drawdowns and what happened afterwards.
Eric: Why don’t we get into a couple of examples for the audience to give them the sense of an extreme event and then maybe an event that was more similar to what we just went through over the last two or three months, just to give them some idea of what these look like and how long it took to recover?
Why don’t you start off with probably the most notorious and extreme event that most people would remember, which would be the financial crisis that was about 10 years ago?
Patti: Sounds good. I’ll take the tough one. Basically, during the financial crisis, if you had 100 percent of your money in the stock market, you lost during that drawdown period 51 percent. It took a year and four months from beginning to end. The recovery took just over three years. That total underwater period was four years and five months. That’s 100 percent invested in the market.
Eric: What you’re saying is for our listeners is the round trip or the peak to peak from the start of the selloff to actually getting back if you were in all stocks was almost four and a half years if you were a buy and hold portfolio.
Patti: Exactly. I was just going to say that. We’re not taking money out of the portfolio. We’re not adding it either. If you take a more balanced approach, 60 percent in stocks, 40 percent in bonds, that drawdown was 31 percent, and the underwater period from beginning to end was three years. Even more a conservative portfolio, 20 percent loss, two years complete round trip.
The takeaway here is that so that a more balanced approach you didn’t go down as far, and your complete recovery period was shorter.
Eric: The lesson is if I buy and hold or if I become more conservative that the drawdown’s going to be less, and as such then our recovery times will be faster. The underwater period will be faster if we take a more conservative approach, but if I’m a long term investor trying to grow for retirement…
Patti: It’s important that we keep all this in context. We’re going to be talking generalities here, but everybody is different. It’s not to say that everybody should have a 40/60 portfolio, 40 percent in bonds, 60 percent in stocks because that portfolio, generally speaking again, on average is going to have a lower long term rate of return than one that would have more in stocks.
Sometimes people need a higher rate of return to accomplish their objectives. What’s the right balance for you? That’s going to be a case by case basis.
Eric: What you’re telling me is there’s no magic bullet. If I’m trying to get good long term returns I have to deal with the drawdowns and the longer recovery period as long as I have enough time.
Patti: Exactly. Let’s now go through an example that is probably closer to what we’ve just experienced, the Russian default on their currency that occurred in 1998.
Eric: This is going back about 20 years now. When the Russian debt default happened this bears a striking resemblance to the selloff that we just had in terms of the magnitude of the selloff but also the duration because it was so fast. Let’s take your example. If you look at a portfolio that’s 100 percent in the US stock market, your portfolio, the maximum drawdown was about 17 and a half percent.
That occurred in a short window of two months. Just as you said before the more conservatively positioned portfolios are going to experience much less drawdown. The other extreme is if you were 40 percent stock, 60 percent bond portfolio, you were only down about 6 percent. In all these cases, despite that extreme drawdown and probably how bad it felt these portfolios, all of them recovered within three months.
Despite a 17 percent selloff or somewhere in between, within a five month period from beginning to recovery, that’s all it took is five months to recover a 17 percent loss. Again, it’s important for people to have some resolve and some resiliency, despite what we went through, that we’ve had periods like this before.
To become very conservative or start making changes…You could probably talk to this…could definitely affect that recovery period if you become more conservative at the wrong time.
Patti: Absolutely. It’s going to take much longer to recover if you make changes while it’s happening.
Eric: After the drawdowns already occurred.
Patti: The worst thing that anyone could possibly do. It’s also important for us to recognize, for those of you who are not feeling great about what happened, it was pretty bad. In fact, we have to go back to 1972. It was the fourth worst drawdown since 1972. The two worst ones occurred between the tech bubble and the financial crisis and that’s a long period of time.
If you’re not feeling great about what just happened, I understand because it was a tough period of three months.
Eric: The crazy part is I’ve been in the business for about 15 or 16 years, so what you’re telling me is I should feel good because the three worst drawdowns happened in the first 15 years of my career. It should be good from this point on, right? [laughs]
Patti: I will tell you something that someone said to me. Because you’ve experienced these at a relatively young age, it will make you and has already made you a better advisor because you’re going to help that many more people go through these periods of time and get on the other side.
Eric: What’s interesting about that, let’s take the other side. Yours truly over here, you have 30 plus years in the business, so you could probably speak to other events and drawdowns that we’ve lived too, going back in the ’90s and even back in the ’80s.
Patti: I was a brand new financial advisor in 1987 with the crash of ’87, 29 percent in one day. It was interesting because the number one selling book the end of that year was “The Great Depression of 1990.”
Eric: Oh, my goodness. [laughs]
Patti: The fear and the hype and all of that was so palpable, and yet it didn’t happen. We want to keep all of this in perspective and make sure that everyone listening understands that this is not that unusual, and we’re going to get on the other side of this.
Eric: What’s interesting is the two examples that we framed are looking at a buy and hold portfolio. They’re going to recover as things come back. What if you’re taking cash flow? That is so important for a lot of our clients and other people who might be listening that are retired and are actually taking money because taking cash flow from the portfolio can have a dramatic, a profound effect on how long the recovery actually takes.
Patti: Not only does it have a profound effect on the numbers, retirees I find feel it more, A, because they’re probably watching television more or they’re reading the newspapers. They’re that much more vulnerable to the headline risk that is out there. That’s all these newspapers and TV is talking about, “The market dropped so much today. The market dropped so much today.”
Meanwhile, that retiree is taking money out. They’re feeling, “Oh, my goodness. I’m not working. I’m never going to be able to recover from this.” Let’s talk about that aspect of it because there are times if we do this incorrectly where that person won’t recover.
Eric: Let’s go into our first example, and you can give us the detail here. You and I, in talking about this and researching the subject said, “What about somebody who just completed a 20 year retirement horizon?” Basically, they retired on January 1999, and they’ve officially completed a 20 year period in retirement.
What would that look like if that person started out with a million dollar portfolio, and they needed to take $40,000 in year one for retirement? What was their experience in terms of the drawdown, how long it took to recover, the underwater period, and where they stand now? Why don’t you dive into that?
Patti: Eric and folks listening, it really depends on their spending policy. If they’re going to be taking a rigid approach to the spending policy, in other words, a $40,000 fixed every year increasing by inflation every year, their outcome, which is all we care about is the outcome is going to be very different than someone who will take a more flexible approach to it.
In that fixed spending policy, you take out $40,000 a year every year, in that, given this period of time, in that situation 100 percent stocks had a drawdown of 64 percent. A lot of loss during that drawdown period and the drawdown period was eight years and six months. The real kicker with this is that person is still underwater.
Eric: Meaning they still are not at a million dollar balance. After 20 years they have less money than they started with.
Patti: That’s exactly right. Whereas if we take a more balanced approach, say a 60/40 blend, the drawdown was almost half at 38 percent. It was still the same period of time, but the recovery was the total underwater period was 13 years. That person has about $1.1 million as of the end of 2018.
Eric: Let’s put a little context here. This person, they started at precisely the wrong time. What we’re talking about here is a sequence of return risk, which is so important for retirees on cash flow. Basically, this person experienced the dot com crash and the financial crisis, a double whammy if you will, in their 20 year period.
Patti: All within a very short period of time.
Eric: Basically, if they started then it took until 2012, 2013 before they finally got back to even despite that.
Patti: Plan B, and you know we’re always big on plan B.
Eric: Advisors love plan B and plan C, right? [laughs]
Patti: Exactly, and by the way, there’s 26 letters in the alphabet.
Patti: Many, many alternatives.
Eric: Have a contingency plan.
Patti: Always. By the way, we’re joking about that. That is so important for all of you to really understand to have a contingency plan, to take a flexible approach to all of these decisions. Plan B is instead of sticking with that $40,000 fixed plus inflation, how about we take that four percent withdrawal each and every year based on the account value at the prior year.
In that case, the drawdown on 100 percent stocks was still painful, that 58 percent. In that situation, your underwater period is closer to 14 years. You did recover, and you did end up with more money, frankly even more money than the prior at $1.4 million as of the end of 2018.
Eric: I guess what you’re saying here is if you took a percentage rather than a fixed dollar amount, assuming you have flexibility in your spending. Basically, if you were getting four percent on a million, you start taking $40,000, but if the market drops and now, you’re at $900,000 you’re only taking four percent of that or $36,000. Having that flexibility leads to a faster recovery rate.
In this case, you actually ended up with a good deal more money at the end of the 20 year period.
Patti: The sidebar to this, Eric, is if you’re taking that flexible spending approach, it’s really important to have a really good buffer in that emergency fund so that instead of taking from the portfolio, you’re making up the difference with that emergency fund.
Eric: The takeaways here are once you go into needing cash flow, asset allocation is supremely important, as well as your spending policy. Those are the two big takeaways.
Patti: It’s especially important in this one, because if you just dial down the equity versus bond, 60 percent in equities, 40 percent in bonds, yes, you still felt that terrible period of time, but the total underwater period was only five and a half years.
Again, in this case, the ending value was almost $1.4 million. In that case, your principal actually grew, and because of that, the way this works, so did your income.
Eric: You know what, Patti, that’s a fantastic point to reiterate. What you’re saying is that a 60/40 portfolio with the same requirements recovered in five and half years versus almost 14 years for the all stock portfolio. Asset allocation, the amount of risk you take in retirement, is unbelievably important to minimize drawdowns and speed up recovery rates.
Patti: Exactly. To me, the perfect approach to this is flexible all the way around. In other words, you can start out with that $40,000 per year increasing by inflation. If you come out of the gate with a great stock market environment, and this portfolio is doing great, that’s actually going to work out really well for you if you just stick to that 40 plus inflation.
If markets begin to crater, especially early in retirement, then the latter is going to be the better alternative.
Eric: Taking the fixed percentage.
Patti: You can flip from one to the other during this entire retirement period. You don’t necessarily have to have anything cast in stone. That’s where the longer term projections really help. Again, things are going to happen.
We’re talking about a bear market that happened so quickly. What is the impact on your longer term financial plan? Are you still tracking well? Should we dial back on the cash flow being taken out of the portfolio?
Eric: It’s a dynamic process. We’re always making decisions. The key is flexibility seems good in portfolio management as in most everything else in life.
Patti: Exactly. It does, but I think there’s something else important, Eric. Flexibility is fine and it’s great, but not when it comes to your asset allocation. I think it’s important for everyone listening to understand that discipline during this process is going to be really key.
Just because markets are going down and even if you’re taking cash flow, it doesn’t mean that you want to change your portfolio allocation to be more conservative and, frankly, maybe even more aggressive.
A lot of people think markets are down, I should ramp up my portfolio and go 80/20 on the portfolio. I don’t know for sure that this thing is over. It could go back down again. We could have a double bottom that is so characteristic of many bear markets.
Eric: The drawdown period might just be taking a breather. It might not be complete.
Patti: It happens more often than not.
Patti: Not a prediction, just be aware of that.
Eric: Perspective, is what we’re getting here, is really important. I know both of us when we talk to different folks on the phone or through email and so forth, there seems to be the sense that this time it’s different. We have this trade wars going on, gridlock in Washington, all these things. Somehow, this is going to be unique and it’s unlike any other thing.
I think the reality is, again, uncertainty is a feature of the investment landscape. It’s always going to be there. The point is, looking at really significant events the dot com crash, the financial crisis, Black Monday, back when the inception of your career started drawdowns of 30 percent or more are very rare. Not that they can’t happen, they’re just not likely to happen.
If you go back to 1980, there’s only been four events, four drawdowns of 30 percent or greater during that time period. Despite those, the market is phenomenally high and has provided a great rate of return over that period.
What about the more intermediate drawdowns, like what we just experienced? They tend to have a higher frequency, right?
Patti: Absolutely. Let’s just really make sure that that’s clear, the point that you just made is really clear. We’re talking 40 years. 40 years is a long term. We’re talking about 1 year out of 10. The hype, the headlines. If it bleeds, it leads when it comes to newspapers.
Patti: They’ve got to really hype it up, and make it awful, and tell people to stay tuned because you have to hear about what’s happening next.
Eric: You always have so many wonderful little sayings that I have to compartmentalize them. I think I’ve heard at least three or four in the short conversation we had that I got to remember to put in the memory bank for the next time.
Patti: Yeah, 30 years will do it to anybody.
Eric: [laughs] What do you say we package this up with a bow here and take us down the runway? What are some observations on recovery periods? What are some of the things people should be aware of? Let’s wrap it up with some key takeaways about what those in our audience should be thinking about as it relates to the drawdown and recovery.
Patti: It’s real clear. If you’ve got 100 percent of your money in the stock portfolio, it’s going to take longer to recover, because it’s got to go deeper down. To do that round trip takes a lot more effort.
Eric: If you’re down 50 percent, it takes 100 percent to get back to even.
Patti: Exactly. If you’re taking cash flow out of the portfolio, it’s even more so. Very, very important. Each person listening today is in a different season of life. Keep that all into consideration. As it relates to cash flow, Eric, as we both pointed out, a flexible approach is going to be the most important thing.
All equities, drawdowns of 30 percent or greater they do happen. More frequent are the 5 to 10s. If you have any money in the market, you got to plan on losing 5 to 10 percent at least once a year. On average, that’s what happened, but as long as you don’t do anything, you haven’t experienced a loss.
Eric: I would say history is never a predictor of future. There’s never a guarantee of what will happen in future drawdowns, but when you observe historically when we’ve had a 30 percent drawdown or greater, an all equity portfolio, if you’re not taking cash flow, usually takes three to four years to recover.
In a lot of instances, drawdowns that are 20 percent or less, sometimes they’re recovered in a couple of months, maybe upwards of a year. That’s been historical experience. Again, going through what we just went through, just keep that in mind, that yes, it’s temporary, but usually within if it’s a fairly minor drawdown a couple of months to a year is the typical time it’s taken to recover.
Patti: The one thing that I really want to emphasize as we close this program today is this is not even taking into consideration that many people listening today are working and probably contributing to your 401(k)s and IRAs. That will accelerate your recovery period. You are buying low. Every paycheck that you make those contributions will accelerate your recovery period.
Eric: What are some key takeaways here that we can? Maybe we’ll end with the quote of…We always like to end with the sage quote from somebody far wiser than both of us.
Patti: To me, and Eric, I think you’ll agree, the key here is lack of diversification will magnify your drawdown. It will extend your recovery period. The theme here is diversification. Don’t make it harder than it already is. Your stock to bond ratio is really critical to manage the risk versus return that you get on your money.
Second point, taking cash flow can dramatically affect your recovery period and the total period that you go through this. Flexibility is the mantra. Rigid spending policies make you more vulnerable to that sequence of return risk.
The third thing is if you are saving money, if you are continuing to work, consider periods like the fourth quarter of 2018 to be a blessing because you bought stocks. You added money into your whether it’s the United States or even worse, the international market, at a deep, deep discount.
We don’t know for sure when it’s going to recover. We seem to be coming out of the gate here in January, but boy, if you can just keep that discipline, don’t change the portfolio. If you have extra cash flow, add to it. That will accelerate your recovery period.
Eric: That is a perfect way. It’s a shame we can’t play a little dramatic music before we end with our quote from our legendary investor, Benjamin Graham, the father of value investing.
It’s so pertinent to this topic of drawdown. What he said was the essence of investment management is the management of risks, not the management of returns. You can probably speak to this.
Returns are something that nobody can really influence or affect, but the management of the risk you take is so critical. That’s something that we can control.
Patti: Absolutely. As with all of the things that we talk about in these podcast, it is so important for you to control the things that you can. Understand that there are things that nobody can control, whether it be US markets, international markets, the strength of the dollar, what’s going on in Washington. We’re not going to be able to control all of that, and yes, it will impact markets.
At the end of the day, the most important thing is to control how much your portfolio experiences the risk that comes along with all that drama.
Eric: Well said.
Patti: That’s it for today’s show. Thank you so much for spending some time with us. If you want to learn more about bear markets and recovery, just head over to our website. That’s at staging.keyfinancialinc.com. You’re welcome to schedule a call with me and with Eric.
By the way, Eric, thank you so much for joining me today. I don’t know about you, I had a lot of fun. You always lighten up these really heavy subjects.
Eric: Patti, thank you. Thank you the audience out there, all of you folks that are tuning into these podcast, and hope you continue to do so, and we bring you ideas that are interesting and relevant.
Patti: By the way, be sure to hit the subscribe button if you liked today’s episode. Be sure to turn on notifications so you don’t miss a single episode.
Eric: Feel free to like it two or three times. [laughs]
Patti: There you go, absolutely. If you have any comments, or if there’s a subject that you want to hear about, let us know. We’re doing this to hear from you. To make sure that it’s making a difference in your life.
Until next time, I’m Patti Brennan. I’ll see you in the next episode.