Since early 2009, the U.S. equity markets have been in a near-unprecedented rise. It might seem an odd time to talk about market risk, in the context of large drawdowns. However, it is exactly the right time because that nearly decadelong run of steady high returns is neither characteristic nor sustainable. We would be wise not to forget that before the 2008 market crash, there was a long period of steady returns and low volatility with a good deal of talk about how we were in a "new normal." Investors thought the business cycle was under control.
We must recognize that any perspective gained from the past nine years of market gains is cherry-picked from history. In reality, the periods between successive market peaks — what we call drawdown periods, or valleys of regret — are an underappreciated risk.
Figure 1 shows a plot of the daily S&P 500 index from June 2008 through March 2012. This drawdown had a length of three years and nine months, attaining at its lowest point a loss of 52%. As is common, the drop to the trough is much faster than the rise back up. The recent market rise discussed above appears in a different light when we realize that much of it was simply the recovery of prior losses.
The index eventually did regain its prior high, but it is naive to think those nearly four years of looking back at the prior peak were not frightening, particularly in the beginning as losses relentlessly mounted.
Capital is never just saved. It is saved for a reason. A couple is saving for a house. A retiree is living off of savings. A pension or endowment fund must meet current obligations. Drawdowns of this magnitude and duration often mean capital is not there when it is needed or that servicing current needs requires a sale of diminished capital.
Even a long-term investor will have the urge to do something to regain lost ground. Unfortunately, that often means taking on excessive risk or attempting to time markets. Such emotions drive us in exactly the wrong directions. There is ample evidence that such panic leads to disaster. It is easy for an investment professional to advise us to stay the course. The reality, when in a valley of regret, is that we often do not.