It's a horrific possibility: During the Great Depression, the stock market fell 89% from peak to trough.
If the Dow took a similar fall from its October 2007 peak, we'd be sitting at Dow 1,500. That's less than a fifth of today's post-mini-rally reading north of 8,500.
Before we all liquidate our portfolios, though, know that Dow 1,500 is my merely my way of ballparking the worst case scenario.
Why talk about the worst case?
While I highly doubt we're going to hit Dow 1,500, it's important to keep the worst-case scenario in mind. We got into this whole financial mess, after all, because very few people considered how things could go wrong.
From Main Street to Wall Street, the assumption was that home prices would go up forever. Why else would purchasers buy houses whose monthly payments they couldn't afford after the teaser rate reset? Why else would bankers from Bank of America (NYSE:BAC) to Goldman Sachs (NYSE:GS) leverage up to lend to these people?
Once housing prices started dropping, skimpy rainy-day funds and bogus financial models revealed just how dangerous and wrong-headed that assumption was.
But here's the thing. It's wasn't the failure to live according to the worst-case scenario that annihilated life savings. It was failure to consider anything but a best-case scenario.
What to do now?
If we lived only according to worst-case scenarios, we'd never get married (half of marriages end in divorce as it is), we'd never have kids (in the long run, we're all dead), and we'd never dance like no one's watching (someone might be … watching).
In the investing world, living only according to the worst-case scenario would mean we'd never buy stocks -- or corporate bonds for that matter. We'd stick to Treasuries, gold, or cash under a mattress.
And that would be a tragedy. If we stayed out of the market because of fear, we'd miss out on the historical gains in the market, our savings would either be eroded by inflation or they would barely keep up, and retirement would be a luxury only for the rich.
But keeping both scenarios in mind -- best case and worst case -- can serve us quite well.
Add it up
Knowing that things can get worse reminds us not to pull a Wall Street and ignore the real downside risk. For example, as my Foolish colleague Joe Magyer warns, we can't trust Wall Street analysts' rosy growth estimates. Thanks to the recent rally, it's easy to believe that the stocks we've seen double from their lows must just keep going higher based on these growth prospects.
What am I talking about? Let's take a prominent example. Starbucks (NYSE:SBUX) shares have indeed doubled off their lows and are selling for 18 times forward earnings. Meanwhile, analysts are calling for 16% annual growth for the next five years. This is even as Starbucks shuts down stores, lays off employees, and faces a determinedMcDonald's (NYSE:MCD) ratcheting up its McCafe efforts. Given that Starbucks grew by only 6% annually the past 5 years, you tell me whether we're getting a little frothy on Starbucks.
But at the same time, it's important to temper our inner devil's advocates with the reality that things will get better.
Let's look at another prominent recent example. If you're one of the folks who recently sold his or her losses and flocked to the safety of supposedly recession-resistant plays like Wal-Mart (NYSE:WMT) and McDonald's, on the theory that discount was where it was at, you missed out.
While discount purveyors remained fairly steady, premium brands rocketed upward. Starbucks isn't the only one that doubled -- Apple (NASDAQ:AAPL) has nearly doubled off its lows, too, and Whole Foods (NASDAQ:WFMI) has tripled!
What we've learned
As hard as it is, we must keep an even keel, using worst-case scenarios and best-case scenarios against each other to hold steady with our long-term investing plans. Trying to time the market and move in and out of stocks based on variable market sentiment only leads to a lot of buy-high, sell-low behavior.
The analysts at our Motley Fool Inside Value investing service have a helpful way of doing this. They keep a list of their five best recommendations on a risk-adjusted basis and one on a pure upside basis. In this way, they make sure to heed both the downside risks and the upside opportunities. They've recently updated their lists. You can see them with a free 30-day trial. If you disagree with their thinking, no worries -- there's no obligation to subscribe.
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Anand Chokkavelu 's mom sometimes says he's the worst-case scenario. He owns shares of McDonald's, Apple, and Whole Foods. Apple, Starbucks, and Whole Foods Market are Motley Fool Stock Advisor selections. Starbucks and Wal-Mart Stores are Inside Value selections. The Fool owns shares of Starbucks and has a disclosure policy.
