Investors with an appropriate understanding of the trade-offs between risk and reward can develop a disciplined investment plan.
The smallness of the army renders the natural strength of the community an overmatch for it; and the citizens, not habituated to look up to the military power for protection, or to submit to its oppressions, neither love nor fear the soldiery; they view them with a spirit of jealous acquiescence in a necessary evil, and stand ready to resist a power which they suppose may be exerted to the prejudice of their rights.
-Alexander Hamilton, Federalist Papers
A necessary evil can be defined as an unpleasant necessity, something that is perhaps undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil. Let's explore why.
Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than a one-month Treasury bill (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred), investing in stocks would not entail any risk - and there would be no risk premium. In fact, in 23 of the 82 years from 1926 through 2007 - or close to 30% of the time - the S&P 500 Index produced negative returns.
In addition, there have been periods when the S&P 500 Index produced severe losses:
- January 1929 - December 1932 it lost 64%.
- January 1973 - September 1974 it lost 43%.
- April 2000 - September 2002 it lost 44%.
The very fact that investors have experienced such large losses leads them to price stocks with a large risk premium. From 1927 through 2007, the S&P has provided an annual risk premium over one-month Treasury bills of just over 8%. If the losses that investors experienced had been smaller, the risk premium would also have been smaller. And the smaller the losses experienced, the smaller the premium would have been. In other words, the less risk that investors perceive, the higher the price they are willing to pay for stocks. And the higher the price-to-earnings ratio of the market, the lower the future returns.
The bottom line is that bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets - while painful to endure - should be considered a necessary evil. We can extend this logic to the risks of investing in small and value stocks.