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FTSE 100 stock market crash: What can it teach investors?

On 23 March, the FTSE 100 market crash ended. On that day, the UK’s main market had fallen by 33% in little over a month, comfortably surpassing the 20% decline needed to define a bear market. The FTSE is actually up around 23% since that day, which means a bull market is here.

However, the FTSE 100 is still a long way short of recovering its losses. A little bit of stock market maths can demonstrate why this is so. If an investment is worth £100 and falls in value by 10% it is worth £90. To get back to £100, the investment has to go up by £10, which is 11.1% of £90. Let’s say instead that the investment fell by 20%. In this case, a £100 investment will be worth £80. To recover the loss, £20 is needed, which will require the £80 investment to grow by 25%. Finally, if a £100 investment falls by 33% to £67, it will take a 49% rise to get back to break even.

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Minimising losses

Whatever the loss, the return needed to break even is larger, and it gets worse as losses get deeper. Losses are difficult to avoid completely because no investor can perfectly forecast the future. Minimising losses is what investors should try to do.

Diversification will help to reduce the size of portfolio losses, assuming it is done correctly. If a portfolio holds one stock, and that company goes bankrupt, then all is lost. A two stock portfolio stands a better chance of not blowing up. In theory, the more stocks that are added to a portfolio, the lower the risk. But consider a portfolio that held 10 airline and oil stocks just before the FTSE 100 market crash that began in February. It would have done worse than the overall market when it crashed. A portfolio of 10 stocks that included one oil and one airline company, but also firms operating in healthcare, tech, food retailing, beverages, and utilities, for example, should have done a lot better.

An investor should not naively add stocks to a portfolio. Just because a firm does something different to the companies already in the portfolio, does not mean it will lower the portfolio’s risk. The new firm might be terrible and in decline, so it is still crucial to assess the fundamentals of any company before investing.

Recovery time

If an investor held the entire FTSE 100, they would have been down 33% in the crash, but up around 23% or so from the lows at the moment. Other investors will have performed very differently. If they were lucky enough to hold some of the stocks that have risen by a lot more than the FTSE 100 average they will be pleased. Those that held a few of the worst-performing stocks might not be so impressed.

Whatever the loss, assuming the companies invested in are viable, then recovery is possible. It might, however, take quite some time. The FTSE 100 has returned 6.4% (including dividends) annually on average over the last 25 years. Recovering from a 33% decline will take around six and a half years at that rate. A 10% annual return will do it in just over four years, and a 25% annual return gets it done in under two. An investor that has patience will be more likely to see their portfolios recover.

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Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.