Successful market investing combines an understanding of how the market and individual stocks behave, with our own reactions to those behaviours. It seems ironic I would write an article about declines at a time when the market looks like an unstoppable train, onward and upward to ever-more-record highs.
In this environment it is, however, best to prepare ourselves for the inevitable bear market, whenever it might arrive. Rest assured, it will arrive! We just don’t know when.
One of the most difficult yet important aspects to understand is that even the best companies periodically experience significant drawdowns — sometimes on their own volition, sometimes as part of a greater market meltdown. The data presented in this article is from an excellent study published in May by Morgan Stanley, titled, “Drawdowns and Recoveries: Base Rates for Bottoms and Bounces.” The U.S.-based study was conducted by an Arizona State University professor and went back a full century, reviewing about 28,600 companies listed in the U.S. during that time; however, most of what I will reference is from the 40-year period between 1985 and 2024.
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Firstly, it is important to understand the difference between median and average. The average is, as we all know, the numerical average of all data points. The median number represents a level where half of stocks performed better and half performed worse. Median is important because the average can be skewed by a few outliers such as Amazon and Nvidia.
Interestingly, going back a full century, 60 per cent of corporations failed to match the returns of Treasury bills, meaning 40 per cent represented the entire wealth creation of the market, with a dramatic skew toward the current list of tech heavyweights. Yet, the top six stocks in wealth creation have, on average, experienced declines of 80 per cent at some point in their history. For example, Amazon declined 95 and Nvidia 90 per cent in the wake of the dotcom bubble 25 years ago yet rallied back to reach their current astronomical $2.5 trillion and $4.2 trillion market caps.
This decline-and-rally behaviour is not unique. In fact, from 1985 to 2024, the median stock experienced a drawdown of 85.4 per cent, lasting 2.5 years, and recovered to 89.6 per cent of previous peak, lasting 2.5 years as well. This means slightly over half the stocks never reached their previous peak. The average stock experienced a decline of 80.7 per cent lasting 3.9 years and rallied back over the next 3.8 years to 338.5 per cent of its previous peak. In simple words, if you see a stock drop dramatically, there is about a 50:50 chance that stock will never hit its previous peak, but those that do can perform extremely well. Generally speaking, the time of decline equals the rally time to next peak.
The larger the drawdown, the less likely a stock will recover to its previous high. Twenty-eight per cent of stocks experienced a decline of 95 per cent or greater, with only 16 per cent of them rallying back to previous high. Forty per cent of stocks experienced declines of 75-95 per cent, with slightly less than half reaching their previous peak. Twenty-six per cent declined 50-75 per cent, with over two-thirds of them reaching their previous high. Astonishingly, only seven per cent of stocks experienced a decline less than 50 per cent and as you would expect, most (80 per cent) went on to achieve their previous high.
Looking forward
That’s not to say money can’t be made on stocks after they experience precipitous declines. A stock that declines 90 per cent and goes on to achieve half its previous peak returns 400 per cent from the bottom. Forward returns were indeed best for stocks that had fallen the most, based on selecting survivors from this group, and recognizing how rare it is to nail a stock’s actual bottom. It’s better to wait for a modest recovery.
What surprised me in the report was how few stocks had declines of less than 50 per cent, and how normal it was to experience declines in excess of 75 per cent or more. If we wish to succeed with stocks, it is important to prepare ourselves mentally for this volatility. While most of the big declines will occur during a major bear market, such as the 2008-09 financial crisis, they can occur independently. This clearly demonstrates the importance of broad diversification, as I have emphasized many times. Understanding that dramatic drawdowns are the norm should help in our behaviour as we experience them in our portfolios.
Investing is both an art and a science. Figuring out which companies will survive and then thrive after a major sell-off is difficult. The science part lies in the financials, and the art part — well, that’s the art part.
The stock market provides vastly superior returns over other investing mediums, in part because of the volatility it experiences. Stomaching, and with experience relishing, the volatility is important to our individual success.
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