Valuation-Informed Indexing #140

by Rob Bennett

You will experience a devastating stock price crash at least once in your investing lifetime. How you come through it will be the primary factor determining whether you achieve your investing goals or not.

This is the hardest point to communicate about how investing works. We are accustomed to engaging in activities in which feedback is provided far more quickly.

Say that you want to determine whether a particular football coach is a good choice for the job or not. You see how he does the first year after he is hired. Perhaps you conclude that the won-loss record he achieves in a single year is not conclusive enough evidence and you give him a second chance. Perhaps there are particular circumstances that come into play that cause you to tolerate two years of poor performance before making a move. But it is unlikely that you would stick with a football coach with a poor record for more than three years. After three years, you are looking to cut your losses and move on.

So it is with a job. You don’t stay at a job that you do not find fulfilling if things do not turn around in a few years. If you watch a new television show two or three times and find it unsatisfying, you go looking for something else. A diet that doesn’t produce results in six months is a diet that failed.

But the only investing strategies that really work are long-term investing strategies. And in the field of investing the term “long-term” can be a good number of years.

In fact, the best investing strategy is the one that gives you the best lifetime results. But the strategy that gives you the best lifetime results is almost surely not going to be the one that gives you the best results at the end of one year or two years or three years. In some circumstances, the best investing strategy will not give you the best results at the completion of 20 years or 25 years or perhaps even 30 years.

That’s why there are so few giving good advice in this field.

To understand the point, you need to spend some time looking at the historical return data. The thing that jumps out is that stock prices always go up steadily for a good number of years (a secular bull market) and then always come down very hard in a short amount of time (the price crash that opens a secular bear market).

Crashes take place quickly. So there is little time to engage in thought or strategizing while the crash is taking place. But the consequences of a crash are permanent and profound. Most of us devote 90 percent of the thought that we direct to stock investing to what happens in non-crash years. But it is what happens in the crash period that has the biggest influence on whether we achieve our goals or not.

There have been four crashes since 1870. The first took place in the early 1900s. The second took place in the late 1920s. The third took place in the mid-1960s. And the fourth took place in the early 2000s. The typical investor invests for roughly 60 years (say, from age 25 to age 85). So, regardless of when a typical investor was born, he would have been hit by at least one of the crashes. We have never gone 60 years running without experiencing a stock crash.

This wouldn’t be such a big deal if crashes were something that came and went. But they are not. The crashes themselves are short-term events. But the effects of crashes are long-lasting indeed.

The best way I can think of to explain this is to remind you of the amazing mathematical calculations that you read about in articles and books aimed at encouraging young people to save. These calculations illustrate the power of the compounding returns phenomenon. Save a small amount of money in your 20s and it will grow to a very large sum indeed over the coming decades as you experience first compounding on the initial sum and then compounding on the compounding returns.

It’s a highly counter-intuitive phenomenon. And yet a very real one. And it applies in the investing realm as much as it does in the saving realm.

The typical stock-crash-loss is about 65 percent of your portfolio. We saw a loss of about that size in the early 1900s, a loss of more than that in the late 1920s and a loss a bit less than that in the 1960s and 1970s. Going by the valuation levels that caused the current economic crisis, we should be expecting losses of at least the magnitude of those that brought on the Great Depression. So it would be fair to describe a 65 percent loss as typical.

Say that you experience this loss near the beginning of your retirement years, either a few years before or after you retire. That would be devastating. Your portfolio will be very large at that point. So losing 65 percent of it will represent a loss of many, many years of saving.

Is it better to experience the loss farther along in your retirement? It’s not too much better. The strange thing about stocks is that, in all the time-periods in which prices are not crashing, prices are moving upwards at a steady pace. That means that, even if you are withdrawing funds from your portfolio to finance your retirement, the odds are good that your portfolio will be larger 10 years into retirement than it will be on the day you retire. Which means that the 65 percent hit will bring on a loss of greater dollar value.

What if you take the stock crash hit early in your investing career, when you are in your 20s rather than in your 60s?

That’s better in one important respect. You will have little money invested in stocks at the time. So the hit will be minor.

But there’s still a “gotcha.” If the crash comes when you are 30, we will be due for another crash in your 60s. So it might be that, instead of feeling the full impact of one crash, you end up experiencing a small hit followed decades later by a big hit. There’s just no way to avoid the effect of stock crashes!

People don’t like to talk about stock crashes or to think about stock crashes. That’s unfortunate. Surviving stock crashes is a big part of the effective stock investing story. By talking about them and thinking about them, we become better able to make investing choices that permit us to limit their ability to undermine our odds of achieving our investing goals.

Rob Bennett has recorded a podcast titled “Market Timing — What Works and What Doesn’t” . His bio is here.