I've started to receive emails about the falling market. The market has been down since May, and people who have never really experienced a correction are living through it for the first time. And they're suffering.
Not to trivialize their pain, but it can get much, much worse.
How much worse?
Well, investors who bought the Dow at the peak of the market in 1929 had lost roughly 89% of their investment only three years later. They broke even, in real terms, in 1954 -- 25 years later. If you include dividends in the mix, it's a bit better. In that case, the breakeven year was 1945.
Let's look at a more recent example -- the market's fall from its highs in 2000. From peak to trough, the Nasdaq fell 79%. Investors who bought at the peak broke even in ... well, actually, they're not at breakeven yet. The S&P 500 fared better, with investors losing "only" 50%.
Such falls can happen again. In fact, I'd wager that a similar fall will happen again in my lifetime -- and if it doesn't, I won't have to pay up anyway, because I'll be dead. But I do think a fall will happen sooner rather than later, because there are some big stresses on the system. Nobody really knows the degree to which high consumer debt, the housing bubble, huge budgetary and trade deficits, and the insane number of outstanding derivatives could amplify a fall. Things could collapse incredibly quickly.
So why invest in stocks?
Of course, despite the risks, I still have a large chunk of my net worth in the stock market. It's not because I think I'm such a great stock picker that in the event of a meltdown, my stocks will miraculously be in the green. In a bear market, pretty well everything falls.
Rather, it's because it's the best game in town. Over the long term, the stock market has outperformed most other investments. And that makes sense. When you're buying a stock, you're buying a portion of a business. You'd expect that most of the time, actively run businesses will be more profitable than more passive investments like bonds. Plus, businesses can be more responsive to changing economic conditions such as inflation.
In addition, the odds of actually buying at the peak before a crash are quite low, and you suffer the massive 80% or 90% loss of capital only if you invest near the peak. But even if you do invest at the peak, if you continue to put money to work in the market, you break even a lot faster.
Who falls the most?
That said, it still makes sense to have a portfolio able to weather any stock market storm. While most stocks tend to fall in a crash, they fall to varying degrees. After the tech bubble popped in 2000, for example, the most overpriced and speculative companies went to zero -- a 100% loss to investors.
The overpriced but solid companies survived, though investors suffered. This group includes the likes of Cisco Systems (NASDAQ:CSCO) and Amazon.com (NASDAQ:AMZN). Both have excellent businesses but became way overpriced during tech mania and have fallen 80% from their peaks.
In the middle are the reasonably priced stalwarts -- dominant businesses trading at fair prices. I'm thinking here about companies such as Procter & Gamble (NYSE:PG) and Best Buy (NYSE:BBY). These companies dropped, but because they weren't completely overvalued in the first place and were still great businesses, they didn't fall nearly as far -- say 40% to 50%. Plus, they bounced back relatively quickly and are now above their pre-bubble highs.
The stocks that did the best, however, were the solid, undervalued, and unloved businesses. During the tech bubble, dividends were unfashionable, and nobody wanted boring real estate, so REITs were completely out of favor. But investors in Vornado (NYSE:VNO) and Boston Properties (NYSE:BXP) barely noticed a blip when the bubble popped -- and those two stocks have more than doubled since then.
The Foolish bottom line
The lesson is that during a correction, solid, undervalued stocks tend to both fall the least and recover the fastest. Furthermore, a strong dividend can provide buoyancy when the market is skittish. That's why even if you have a high-risk portion of your portfolio, it makes sense to have a core of undervalued blue-chip companies that can provide a decent return when the market's hot and a safety net when it's not. These are the sort of companies that we identify in our Inside Value newsletter. You can see what it has to offer -- including all of our previous picks -- with a 30-day free pass.
Fool contributor Richard Gibbons never swings on the high trapeze without a safety net. He owns call options on Cisco but does not have a position in any other security discussed in this article. Amazon.com and Best Buy are Stock Advisor picks. The Fool has a disclosure policy.
