I often note that, on the three earlier occasions on which U.S. stock prices went as high as they are today, we experienced an average price drop of 68 percent. There is no one number that tells you all that you need to know about stock investing. So I will today direct a few words to an effort to putting that 68-percent-price-drop number in context.

It is of course possible that we will not see a price drop that big. Today’s P/E10 level is 24 (this blog entry was written in advance, so this number may be slightly out of date when you read these words). In the mid-1960s we saw a P/E10 level of 24, but the subsequent price drop was only 56 percent. That could happen again.

Or it could be that we will not even see a price drop of that magnitude. We have only been to a P/E10 level of 24 three times. The fact that we have never seen a price drop in these circumstances of less than 56 percent is certainly an indication that it is not wise to rule out seeing a price drop of at least that magnitude this time. But three spins of the wheel is not very many spins of the wheel. It could be that this time we will see a price drop of a bit less than 56 percent. Perhaps our small sample of return patterns is biased to the down side. We know that we cannot count on that. But we do not know with certainty that it is not so.

A price drop of 68 percent sounds real, real bad. Think about it a bit and you will see that it is not quite as bad as it first appears to be. The 68 percent price drop does not take place in a single year. It is spread out over time. It might be that you would suffer a loss of something in the neighborhood of 20 percent for four years in succession, or even that there might be some up years mixed in with a greater number of down years in a way that produces an overall loss of 68 percent when all the ups and downs are mixed in together. The loss of wealth is of course still very bad. But a loss that takes place over a good number of years will not be experienced as being nearly as dramatic an event as one that took place quickly. It would not surprise me if many investors will not even be aware that they have suffered a 68 percent hit after they have done so.

The 68 percent hit is the hit that applies at the worst possible moment. At all times other than the worst possible moment, the hit will be less than that. If you go far enough out into the future, there will be no hit at all. If you go far enough out into the future, there will be a big gain. It helps to keep these things in perspective.

Presuming that you are not going with a 100 percent stock allocation, you will not be seeing a 68 percent drop in your overall net worth number. If stocks comprise 90 percent of your portfolio, your overall hit will be about 60 percent. If stocks comprise 60 percent of your portfolio, your overall hit will be about 40 percent. If stocks comprise about 30 percent of your portfolio, your overall hit will be about 20 percent.

The 68 percent number does not incorporate the effect of dividends earned during the time the price of your stocks was falling. Including dividends (which is proper) makes things sound a lot less dramatic. John Walter Russell did research showing that the loss with dividends included might be only 40 percent. In a world in which most investors were better informed about the realities of stock investing, I think the 40 percent number would be the better one to report. The reason why I usually report the 68 percent number (and then add a mention of the 40 percent number if space permits) is that investors have been (improperly, I think) trained to think in terms of stock price changes rather than in terms of real net worth changes (which are more significant, in my assessment).

Stocks are in the Red-Light-Danger Zone today. Stocks are dangerous at today’s la-la land price levels. The potential for a big price rise is small. The risk of a big price drop is big. I believe that most investors (those not possessing strong stock-picking skills) should be limiting their stock allocation to 25 percent or 30 percent until prices return to more reasonable levels.

Still, I don’t think it is at all a good idea to exaggerate the risk that applies. Exaggerations cause emotional reactions. When Passive Investing enthusiasts underplay the risks of owning stocks at these prices levels, they encourage emotional reactions when the price drops come. It’s just as much of a mistake for Rational Investing enthusiasts to overstate the risks.

A 68 percent price drop is a serious thing. The fact that the historical data says that that is the price drop we need to be prepared for today is not a reality to be ignored. But a 68 percent price drop is not the end of the world. Do you know what happened on those three earlier occasions in which we experienced a average price drop of 68 percent? Stock prices shot up from the depressed levels that investors’ negative emotions had taken them. Lots of folks got rich in the aftermath of those earlier price drops.

Middle-class investors as a collective unit are likely going to experience a severe hit in years to come. Those positioned to survive the hit are likely going to amass large amounts of financial freedom quicky indeed in the aftermath.

Today’s Passion: If you’re not prepared for the good times just now beginning to be visible on the distant horizon, read the article entitled Stock Boom Facts and start salivating.