How Risky is the Stock Market – How accurate are your perceptions? (Quiz)

“Half the lies they tell about me aren’t true.” – Yogi Berra

 

We talk with people and read articles and books every day about investing, and are constantly shocked at how little most people know about the real risks and returns of the stock markets. The bear market of 2008 has only made the misconceptions worse.

This is a critical topic because inaccurate perceptions tend to lead to inappropriate actions with your investments. You may fear things you don’t need to fear and you may not be cautious about things you do need to fear.

Is your investment strategy and outlook based on inaccurate perceptions?

The main reasons for these misconceptions are:

1. Many people view life emotionally, which results in an exaggerated view of both the risks and the returns.
2. A great many news stories, articles, web sites and books quote stock market returns based on the raw index, which excludes dividends, instead of the total return index.
3. News articles, of course, present exaggerated views.

Do you have a clear idea of how risky the stock market is? What is normal volatility, what worst-case scenarios are likely to happen, and what returns are reasonable to expect long term?

A list of questions is a good way for you to measure how accurate your perceptions are. These questions were chosen to highlight some of the most common misconceptions and stock market myths.

The source for each answer is shown and you could look them up, but you will be able to measure your perceptions if you just answer them directly in 5 or 10 minutes.

Many of the answers came from our own research. We took the calendar returns of the S&P500 in U.S. dollars since 1871 and analyzed them. The S&P500 is the broadest index with documented returns since the 1800s. Note that using monthly or daily data would show somewhat more extreme results.

The period during the Great Depression dominates all the extreme stats. It is questionable whether that level of volatility could happen again, since the government did not know how to manage an economy back then. They made it far worse after the initial crash by raising taxes and interest rates, and not standing behind bank deposits. So, we will present relevant stats with and without that period. To be fair, we will exclude the recovery period as well as the crash.

 

How accurate are your perceptions? (Quiz)

Here is a list of questions to test your view of stock market risk and return. If you score:

10-12    You have an excellent grasp of markets.

7-9          You have a moderate understanding.

0-6          You need to get educated.

 

1. Short term risk

What is the worst calendar year loss? ¹

Including 1930s                        Excluding 1930s

1. -44%                                      -37%
2. -54%                                      -47%
3. -64%                                      -52%
4. -74%                                      -57%

 

2. Worst-case scenario risk

What is the worst total multi-year loss from top to bottom (calendar years)? ¹

Including 1930s                         Excluding 1930s

1. -63%                                       -38%
2. -73%                                       -48%
3. -83%                                       -53%
4. -89%                                       -63%

 

3. Making nothing for decades

What is the longest period of time without a gain (calendar years)? ¹

Including 1930s                         Excluding 1930s

1. 14 years                               10 years
2. 19 years                               14 years
3. 22 years                               16 years
4. 26 years                               22 years

 

4. Secular bear markets

Many articles have been written about long periods of time when the markets make virtually nothing. What are the actual returns per year for the last 2 secular bear markets? ¹

1929-49                                1966-82

1. -0.3%                                   -0.1%
2. 2%                                        0.7%
3. 5%                                        3.2%
4. 7%                                        6.7%

 

5. Recovery from a loss

From the bottom of a bear market, what is the longest period of time until the entire loss was recovered (calendar years)? ¹

Including 1930s                         Excluding 1930s

1. 10 years                                 4 years
2. 15 years                                10 years
3. 18 years                                13 years
4. 22 years                                18 years

 

6. Worst-case long term returns

What is the worst 20-year return per year? ¹

Including 1930s                         Excluding 1930s

1. -9.8%                                      -4.7%
2. -5.4%                                      -1.3%
3. -2.6%                                      +0.5%
4. +3.1%                                     +5.0%

 

7. Bear Markets

A bear market is generally defined as a loss from top to bottom of 20% or more. Since 1950, how many bear markets have there been? ³

Canada (TSX)             U.S. (S&P)

1. 5                              7
2. 9                              5
3. 13                          13
4. 17                          15

 

8. Recent returns by asset class

Looking at recent returns for the last 30 years from 1978-2008, which is the correct order of returns from highest to lowest? (Real estate figures from Toronto Real estate Board) ^4&5

1. Gold, Canadian stocks, Real estate, US stocks, GICs
2. Real estate, Canadian stocks, US stocks, Gold, GICs
3. US stocks, Canadian stocks, Real estate, Gold, GICs
4. US stocks, Canadian stocks, GICs, Real estate, Gold

 

9. Growth of $100 since 1950

The investing time horizon for the average person is about 60 years (approx. age 25-85). Conventional wisdom advises us to allocate our investments between stocks, bonds and cash (T-bills). What would $100 invested in 1950 have grown to invested in each asset class (to the nearest thousand)? ³

1. Cash $3,000, Bonds $8,000, GICs $8,000, Global stocks $11,000, Canadian stocks $12,000
2. Cash, 3,000, GICs $8,000, Bonds $11,000, Canadian stocks $22,000, Global stocks $30,000
3. Cash $3,000, GICs $6,000, Bonds $7,000, Canadian stocks $30,000 , Global stocks $49,000
4. Cash $3,000, GICs $5,000, Bonds $6,000, Global stocks $76,000, Canadian stocks $105,000

 

10. Keeping up with Inflation – Consistency of returns

How predictable are long term returns? The real return of stocks (after inflation) since 1802 is 6.8%. How do the after inflation returns compare by market era (1802-71, 1872-1925, 1926-2006)? ²

1. 0%, 6.6%, 6.8%
2. 1%, 6.3%, 9.0%
3. 0%, 4.8%, 5.6%
4. 6%, 5.6%, 11.2%

 

11. Keeping up with inflation – Worst case scenario

Inflation is the enemy of the long term investor. What are the after-inflation returns per year for the worst 10-year period since 1802? ²

4. Stocks -4.1%, Bonds -5.4%, T-Bills -5.1%
5. Stocks -11.0%, Bonds -10.1%, T-Bills -8.2%
6. Stocks -15.2%, Bonds -3.4%, T-Bills -1.1%
7. Stocks -31.6%, Bonds -15.9%, T-Bills -15.1%

 

12. Keeping up with inflation – Medium term risk

What is the correct order of risk over 20-year periods (based on the standard deviation of after-inflation returns since 1802) from lowest to highest risk? ²

1. T-Bills, Bonds, Stocks
2. Bonds, T-Bills, Stocks
3. T-Bills, Stocks, Bonds
4. Stocks, T-Bills, Bonds

 

Below are the answers. How did you do?

We would like to have an informal poll, so we would appreciate it if you would tell us your score, and possibly in which area your perceptions were wrong (if you are not too embarrassed). If your score was low, you are not alone. An article to follow shortly will provide explanations.

Answers:

1. 1
2. 1
3. 1
4. 4
5. 1
6. 4
7. 2
8. 4
9. 3
10. 1
11. 1
12. 4

 

Ed

 

Sources:

1 Our own research by analyzing the calendar total returns of the S&P500 in US dollars since 1871.

2 Classic book “Stocks for the Long Run” by Prof. Jeremy Siegel that has data from 1802-2006.

3 Morningstar as shown in Andex Charts.

4 Morningstar.

5 Toronto Real Estate Board.