Morningstar Advisor - February/March 2009 - (Page 29) Exhibit 1: Mind the Gaps U.S. large-cap stocks have made impressive gains over the years, but several significant declines have interrupted the S&P 500’s trajectory. 10,000 Growth of $1 invested in S&P 500 Highest cumulative level of S&P 500 as of date point Crash of 1987 Dot-com bubble burst 1,000 1969 recession 100 10 Crash of 1929 and Great Depression Arab oil embargo 1962 bear market 962 1 Post-war manufacturing crisis 1925 1930 1935 940 1940 1945 1945 1950 1950 1955 1955 1960 1960 1 1965 1970 1975 1980 1985 1990 1995 2000 2005 Growth of $1 includes reinvested dividends. Monthly data used to calculate returns. more sobering, however, is that the secondgreatest decline took place within the past decade. With the crash of the Internet bubble in 2000, the S&P 500 lost almost 45% of its value over a two-year period and took four years to return to its peak value. In all, including the current crisis, the S&P 500 has suffered eight peak-to-trough declines of more than 20% since the mid-1920s. Two of the three greatest declines occurred in the past eight years. To suggest that the current crisis is a once-in-a-century event ignores the record. Measuring Risk: The Standard Model With 20% declines occurring, on average, every decade or so, you’d think that the standard risk models that investors use to make their asset-allocation decisions would assign a significant probability that these events will occur. Think again. To see why, we need to look at the history of how these models were formed. To help make sense of the highly complex capital markets, financial economists in 1960s and 1970s developed a set of mathematical models of the markets that are used to this day throughout the investment profession. The best known of these models are the capital asset pricing model of expected returns and the Black-Scholes option pricing model. These models’ creators have won the Nobel Prize in economics for their path-breaking work. Each of these models starts by making an assumption about the statistical distribution of stock market returns. The CAPM assumes that returns follow a normal, or bell-shaped, distribution. The BlackScholes model assumes that returns follow a lognormal distribution.4 4 For returns to follow a lognormal distribution means that logarithm one plus the return in decimal follows a normal distribution. MorningstarAdvisor.com 29 http://www.MorningstarAdvisor.com
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