Brent Sheather: Don't panic when those stocks take a plunge

What's the biggest worry when investing in shares? For many people, it's the fear of losing the lot in some huge crash, as happened in the 1930s.

However, until recently that scenario has been routinely dismissed by most experts as unlikely. Back in the 1930s, governments and central banks weren't as smart as they are now, we're told.

But of late things have changed for the worse. Luminaries such as Kenneth Rogoff, professor of economics at Harvard University, wrote in the Financial Times that, four years into this financial crisis, it is becoming increasingly clear that this isn't your normal recession, but much deeper and more prolonged.

He refers to it as the "second great contraction", the first being the Depression. Similarly Nouriel Roubini, who is widely credited as forecasting the 2008 meltdown, also writing in the FT, believes that not only is recession assured, but only sensible policy decisions from politicians can stop a second depression.

Joseph Stiglitz, winner of the 2001 Nobel Prize in economics, in another FT contribution, says: "When the recession began there were many wise words about having learned the lessons of both the Great Depression and Japan's long malaise. Now we know we didn't learn a thing. Our stimulus was too weak, too short and not well-designed. The banks weren't forced to return to lending.

"Our leaders tried papering over the economy's weaknesses - perhaps out of fear that if we were honest about them, already fragile confidence would erode. But that was a gamble we have now lost. Now the scale of the problem is apparent, a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario."

Scary stuff. But exactly what did happen to sharemarket investors in the Great Depression? Did everyone really lose everything and then jump out the window?

Economist J.K. Galbraith writes in his excellent book The Crash of 29: "A suicide wave was in progress, and 11 well-known speculators had already killed themselves. Clerks in downtown hotels were said to be asking guests whether they wished the room for sleeping or jumping."

Things are looking grim today so, in the hope of saving a few lives, the next two columns will look at what really happened to two prudent sharemarket investors - one wanting growth, the other income.

This instalment tracks the performance of the portfolio of an individual saving for retirement through that period (Uncle Sam), and in two weeks' time part two will look at the impact of the crash on the portfolio of Aunt Daisy, who is retired and for whom the income-producing ability of the portfolio was especially relevant.

To make the analysis simple, we will assume that both investors' portfolios were invested totally in US stocks; pretty risky, but what the heck - it's August 1929, the stock market has risen by almost 80 per cent in the last two years, cocaine is legal and everyone and everything is buzzing.

Even President Coolidge is hyped: in his December 1928 State of the Union address, he says: "No congress of the United States on surveying the state of the union has met with a more pleasing prospect than that which appears at the present time."

The 100 per cent shares asset allocation decision will also serve to amplify the impact of the crash, because stocks are typically more volatile than bonds and sensible people have some of each. Let's further assume that Uncle Sam, who is saving for retirement, was aged 31 in August 1929 and has invested $10,000.

We have picked August 1929 as our starting point because it was the peak of the 1920s bull market, the very worst time to invest in the US stock market. The analysis uses data for the entire US stock market index (all the shares in the market weighted according to their size) from Ibbotson and Associates' yearbook.

The graph charts the history of Uncle Sam's portfolio in the subsequent 27 years until his retirement in 1956. It kicks off with the crash of October 29 (a fall of 20 per cent), followed by a 25 per cent drop in calendar 1930, a horrifying 43 per cent plunge in calendar 1931 and a further 8 per cent in 1932.

The following year, however, saw a 54 per cent gain, and the market finished 1934 about where it started, then rose by 47 per cent in 1935 and 34 per cent in 1936. Talk about volatility - it took Uncle Sam 27 years to get his original $10,000 back after adjusting for inflation but excluding dividends.

The graph thus highlights another important lesson about shares - they can require a very long-term commitment - selling out after even 10 years would have seen Sam lose about 60 per cent of his money.

The first thing to notice about the performance of Uncle Sam's portfolio is that he didn't "lose the lot", but he certainly could have had he not diversified as widely as he did or if he had become depressed and sold out, as so many no doubt did.

In fact, the most Uncle Sam could have lost had he sold at the market low was 85.9 per cent, in June 1932. At that point, the US market was yielding an attractive 6.5 per cent, but you can bet that with almost all the money gone, Uncle Sam's wife would have been telling him how stupid he was.

However, Uncle Sam had the last laugh. In the 27 years to his retirement in September 1956, his portfolio returned 7.5 per cent a year with inflation included, versus 2.9 per cent a year for government bonds and less than 1 per cent for bank deposits.

Uncle Sam beat inflation, too, which averaged just 1.7 per cent a year. So pre-tax, pre-fees, Uncle Sam made a real return over the period despite buying in just ahead of the worst bear market in the last 100 years.

The reasons Uncle Sam's portfolio held together were threefold: first and foremost, he didn't panic and sell. If he had sold out at the bottom in June 1932 and stuck the money on deposit, his $10,000 nest egg would have been worth only $2000 at retirement. The second important point was that Uncle Sam, because his portfolio tracked the market average, had lots of money in blue-chip names like General Electric, American Telephone and Telegraph and General Motors.

Sam had only small weightings in the speculative, highly geared investment trusts so popular at the time. Being widely diversified was critical to his financial health.

The third reason Uncle Sam didn't feel the urge to jump was because, despite falling dramatically, his portfolio continued to produce cash dividends and it was these cash dividends that generated almost all of his return.

Although the crash must have been a terrible time - 1987 was bad enough - it inevitably had some humorous moments. J.K. Galbraith writes: "Outside the Exchange in Broad St a weird roar could be heard. A crowd gathered. Police Commissioner Grover Whalen became aware that something was happening and dispatched a special police detail to Wall St to ensure the peace. More people came and waited, though apparently no one knew for what. A workman appeared atop one of the high buildings to accomplish some repairs, and the multitude assumed he was a would-be suicide and waited impatiently for him to jump."

Next time we will look at how the 1929 crash affected the portfolio of an individual relying on the stock market for income. We will also consider what we can learn from those turbulent times.

Brent Sheather is an Auckland-based authorised financial adviser. His adviser/disclosure statement is available on request and free of charge.