Friday, June 19, 2009

A 200 Year Flood? Don't bet on it.

For some time now, I've been listening to stockbrokers describe the 2008 Bear Market as a 200 year flood - a freak event that we should assume will never happen again in our lifetimes. The idea is to reassure investors that its safe to stay in or get back into the stock market.

While the 200 year flood is a very comforting metaphor, it's also dangerous, harmful and inaccurate.

The reality is that the recent bear market is one of 5 that saw stocks drop around 50% or more in the last 80 years:

Bear market (how much stocks lost)
2007-2009 (58%)
2000-2002 (49%)
1973-1974 (48%)
1937-1942 (60%)
1929 - 1932 (89%)

On average we have had one of these event every 15-20 years! Hardly a 200 years flood. In fact the last one ended in 2002 - a mere 7 years ago.

So what does this mean for investors?

It means that a critical part of investing is planning for and learning to live with floods: have realistic expectations, at least 3 years of living expenses in cash or AAA short term bonds, and a clear plan for riding out the next storm.

The stock market is still a great investment.

Even with all the corrections and bear markets, it normally delivers returns of about 10% per year. This is great - it means your money would double every 7 years or so! The key is investing with your eyes open and not taking risks you can't afford.

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