Morningstar Advisor - February/March 2009 - 33

For example, in Exhibit 5, we plot the probability of a cumulative loss of 50% or more over various time horizons using the lognormal distribution for the S&P 500 that we show in Exhibit 2 and the log-stable distribution in Exhibit 3. The lognormal model shows that the risk of such a severe decline over an extended period is negligible. The log-stable model, on the other hand, indicates that such a loss over an extended period has a probability of 4% to 5%—numbers significant enough to gain the attention of risk-averse advisors and investors who might want to be prepared for such a scenario. Conclusion We Are Not Alone The uneven performance of the stock market is hardly unique to the United States. Severe declines—mostly within the past decade—have occurred in developed markets since January 1970. Here are the worst declines for seven countries. Country Peak Trough Decline % Recovery Germany Japan U.K. Italy Spain France Canada February 2000 December 1989 August 1972 June 1973 April 1974 August 2000 August 2000 March 2003 April 2003 November 1974 December 1977 November 1979 March 2003 September 2002 67.89 67.62 64.73 59.39 58.81 58.28 47.11 April 2007 To Be Determined January 1977 September 1980 March 1984 March 2007 September 2005 In every financial crisis, investors relearn the same message—there isn’t a magic risk measure or model that can account for or predict every significant drop in the market. Economists and quantitative analysts have made incredible strides over the decades engineering new ways to explain the distribution of returns. These developments provide investors with valuable information to help them decide how to allocate their portfolios for any number of investing scenarios and mitigate risk. But they are not perfect. As we’ve shown, the record contains a much bumpier ride than many risk models would suggest. In addition to preparing clients’ portfolios for these occasional severe declines and taking other precautions, advisors would do well to keep reminding their clients of the risks they face as investors. Clients should 50% 0 be fully prepared to take on the 100-year floods they will surely face in the future. K -10 -20 Paul D. Kaplan, Ph.D., CFA, is Morningstar’s vice president of quantitative research and a 30 frequent contributor -30 to Morningstar Advisor. -40 -50 10 Source: Morgan Stanley Capital International and Morningstar EnCorr. Chart shows monthly return data in local currency for major stock-market index in each country. The Japanese market has yet to recover from its peak in December 1989. 100 10 1 1970 1975 1980 1985 1990 1995 2000 2005 The markets in four of the seven countries have performed worse since October 2007 than the U.S. market, which has fallen 40%. Italy Decline % Japan –47.44 Germany –43.04 France –42.14 Spain –39.42 Canada –34.85 U.K. –31.26 –48.69 Data through December 2008. Based on monthly returns. MorningstarAdvisor.com 33

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Morningstar Advisor - February/March 2009

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