It’s been nearly 10 years since the global financial crisis bottomed out. Since then stocks have basically been on an uninterrupted tear, with the TSX doubling in value, and the S&P 500 nearly quadrupling in value. In that time, investors have survived the European debt crisis, Greece’s debt crisis, a Russian financial crisis, the Brexit decision, Trump’s election, and countless other doomsday predictions.
Markets have reached all-time highs so frequently that investors are understandably nervous about an upcoming crash. The problem is, nobody knows when a crash might hit, if ever, or how severe it might be if it does occur. Stocks may continue to go up for a few years, or maybe go sideways for a while, or we might suffer a small correction of 10-15 percent before the next bull market begins.
The tech bubble and financial crisis are still fresh enough in our minds to convince investors that declines of 40-50 percent are normal, when in fact these were major black swan events that perhaps we’ll never see again.
Investing at all-time highs
Let’s say you’re a nervous investor who decided to get out of the stock market at some point in the last 10 years, whether due to Europe, Brexit, Trump, or simply because the markets were looking “expensive”. What’s the cost of waiting for a correction? It turns out to be quite high.
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch
The Cogent Advisor blog looked at U.S. investment returns over the period 1927 through 2016. That’s 91 years, or 1,092 months. The average monthly return was 0.95 percent. But when they removed the returns from the best performing 91 months, the remaining 1,001 months provided an average return of virtually zero (0.1 percent). In other words, 8.5 percent of the months delivered almost 100 percent of the return.
Their takeaway: Even if you believe the probability of a correction is high, it’s far from certain. And when the correction doesn’t happen, the expected opportunity cost of having waited is much greater than the expected benefit.
The Crash That Never Came
One reader who I’ll call Jason emailed me and confessed that while he used to invest in index funds he got nervous after Trump’s election and moved everything to a full service wealth management firm last year. He didn’t say in the email, but I can imagine he stressed this concern with his new advisor, who placed him into a conservative portfolio aimed to provide downside protection in the event of a crash.
Here’s Jason, one year later:
I just took a look at the past 12 month performance and it was 3 percent vs the market of ~13 percent. I have a sinking feeling I made a mistake and should move it back to self manage using index funds. I sent my advisor a few questions and basically got the answer that they protect the downside, and have a lower risk targeting 4-6 percent average over five years.
I still feel nervous, but at age 42 I think I should be more in the market. We have been at all-time highs for a while so I am torn between a bear market that may start now and the downside protection would be warranted. That said, maybe not.
It’s quite common for investors to act on their fears and make a move like this. Jason got exactly what he asked for from his wealth manager, except for the crash that never came. Now he’s upset that he missed out on last year’s gains, but he can’t have it both ways. If you’re a full participant in the stock market then you take the good with the bad. The idea of stocks for the long run says the good outweighs the bad – that’s why we invest.
Bottom line: Investors need a portfolio that’s built for their risk tolerance and time horizon. If you’re two years away from retirement and worried that a stock market crash will derail your plans then it’s probably not a good idea to have your entire portfolio in equities. On the flip side, if you’re decades away from retirement and don’t plan to access your investments until then, stop trying to guess which way the markets are headed and stick to your long-term plan.
Your investment strategy is only as good as your willingness to stick with it, even in the face of uncertainty. No strategy, not even Warren Buffett’s, is in favour 100 percent of the time. Diversify your investments by owning Canadian, U.S., and International stocks. Instead of market timing, hedge your anxiety with a healthy dose of bonds to smooth out the ride.
As for Jason’s dilemma, I’m tempted to tell him to stick with his wealth manager. To me, that’s a better approach than changing strategies every year. Imagine if he switches to a portfolio of index funds (all equity) and the big crash finally happens next year. He’ll be crushed.
What’s your take? Have you made moves inside your portfolio to ‘protect’ against a crash? How did that work out for you?