The Dow Jones Industrials (^DJI +1.24%) have climbed to record highs on multiple occasions this year and are once again near their all-time high-water mark. Yet as good as the past several years have been for stock investors, you always have to be prepared for the risk side of the risk-reward equation to reassert itself.
Yesterday, we noted how by one historical measure, the Dow could easily climb to 19,000 without it being anything more than a typically average bull-market rally. Yet on the other side of that coin, investors also need to be aware of the possibility that a decline could send the Dow falling to 9,400 or below without being anything more than a typically average bear-market plunge.
Source: Wikimedia Commons, Jean-Pierre Lavoie.
Historically, what goes up must come down
When bull markets will end is notoriously difficult to predict. Some have taken just two or three years to run their course, while others have lasted a decade or longer. Despite the dramatic bounce from the financial-crisis-driven lows four and a half years ago, it's entirely possible that stocks could keep rising from here.
Eventually, though, bull markets have always given way sooner or later to bear markets, sending major market averages down by 20% or more. According to figures from Nobel Prize-winning economist Robert Shiller, you can find 15 previous periods in which downward-moving markets lasting three months or more and including at least a 20% drop from the previous bull market's high. Historically, the average loss under such circumstances has been 40%. That means if the bull market were to end today, you could expect on average for the Dow to drop to about 9,400, based on the recent highs in the Dow around 15,700.
Investors have gotten used to relatively short plunges that have quickly reversed themselves. For instance, as brutal as the financial crisis was, stocks hit bottom relatively quickly, with just a year and a half or so passing between the Dow's 2007 record highs and its early 2009 lows. By contrast, the average bear market has taken almost four years to play itself out. That means that a long time could pass before you were even aware that the bull market had ended, and even once it became clearer, you still couldn't bank on having it over quickly and painlessly.
Dow 2,400?
Of course, a 40% bear market drop wouldn't be history's worst performance. That honor goes to the period following the Crash of 1929, in which stocks lost 85% of their value. A similar drop would take the Dow down to 2,400.
The point, though, isn't to scare you into thinking that losses of this magnitude are inevitable. There have historically also been more modest declines even during bear-market periods. But part of stock market investing is being aware of the potential risk involved and understanding in advance how you'll respond if the worst-case scenario actually happens. In that light, being prepared by embracing strategies like portfolio diversification and asset allocation can help you survive the next bear market -- no matter when it comes or how bad it happens to be.
