The last 18 months has provided stock market investors with a very bumpy ride. There was the large drop from January 2022 to the end of September and then a recovery from September to February 2023. The market has been up and down since then.
This volatility is not new to the stock market. It is actually quite common. Investors who have been exposed to the stock market for more than 10 years have seen their share of drawdowns and subsequent recoveries. The stock market has yet to recover fully the paper losses from January 2022 – September 2022.
Most long-term investors believe that their portfolios will recover from short-term losses. If this is a fact, then investors can reliably predict their expected rate of return.
For example, if a client’s portfolio drawdown is 20% (peak to trough drop), then they should expect their recovery rate of return to be more than their drawdown percentage. In this case, a full recovery would require a 25% return. Simple arithmetic. The question is how long?
In most cases where I ask a client if they believe their portfolio will recover, the answer is yes. When I ask how long, the percentage drop typically dictates the length of time for recovery. The larger the drop, the longer the recovery. In a 20% drop (bear market territory), clients can typically tolerate a 3-year recovery period. We know that a 20% drop requires a 25% recovery. Over a 3-year period, the annualized compounded rate of return must be 7.7% to earn 25% cumulative. Over a 2-year period, the annualized return is 11.8%.
Going forward, don’t let drops in the market instill doubt in your portfolio. If you have faith in the market and its ability to recover, then calculating your expected rate of return is easy. It’s just math.
