Last week, I heard two of my friends talk about an impending market crash. One of them told me he has been doing well in the stock market since he invested in the beginning of this year. But he does not think that the market will stay at these lofty levels for too long. The other guy, who I don’t think has any money in the stock market currently, is convinced that the market is due to crash in 2018. He said it will wipeout all our investments.
A few months earlier, a friend’s wife sought my advice on where to invest her savings. She is a teacher and has been earning a steady paycheck for more than five years. She doesn’t need to spend this money. Her husband’s income takes care of the household needs. But she’s been saving in cash entirely and now regrets she didn’t invest in the stock market earlier. My advice to her was to invest her money gradually (once a year) in an equity index fund, spread it out over five years, and don’t change her investing schedule regardless of how the market behaves over the next five years. My reasoning was (a) she can invest for the long term given her lack of immediate needs and (b) she would be less inclined to give in to market panics (or exuberances) if she follows a predetermined investing schedule. Well, they took the advice well, went home to ponder over it, and came back a week later to tell me they weren’t going to invest in the stock market after all. Her main concern: the market has been going up for too long, it is bound to crash soon, and we’d rather stay on the sidelines and wait for it to crash before we invest.
If you watch financial media these days, you will find many talking heads expressing similar sentiments: the market has been going up uninterrupted for too long, it is due for a deep correction if not an outright crash, this bull market is a little long in the tooth, and so on.
When so many folks are fearing a looming market correction (or even a crash), why am I still invested in the stock market? About two-third of my net worth is invested in the stock market (in equity funds and individual securities) – the rest is in cash and real-estate. See my portfolio. So why don’t I cash out completely and stay out of the market until the imminent market correction takes place? Do I know more than these market experts in the media or among my friends? No and no.
– Howard Marks, “The Most Important Thing”, ch: “Knowing What You Don’t Know”
I don’t plan to get out of the market and yet I don’t claim to have some special insight that others lack. Here are my reasons for staying invested:
- No one can predict the future with certainty. The market may crash next year but I can’t say it with confidence. Getting completely out of the market on the basis of an uncertain event is not what long-term investors do. If I get out of the market completely and the market keeps going up instead of falling, I would lose a significant opportunity of capital gains. If I know something about the market with high level of confidence and I believe very few other market participants are aware of it then it makes sense to do something unusual (like cashing out). But it almost never happens. I don’t claim to have any particular insight into the markets today. So I follow my default behavior pattern: staying invested.
- The market is known to price in any widely available information or popular sentiment. If most participants believe that the market is over-valued, there is a good chance it is not. Why is that? The stock market is not a natural phenomenon (e.g. like the sun rising from the east) where people’s opinions don’t affect outcomes. In the stock market, opinions do affect outcomes. If most market participants believe the market is over-valued, they would have already acted upon their beliefs by selling out of it, and thereby the prices would have already become lower. Ken Fisher in his book The Only Three Questions That Count explains it like this:
– Ken Fisher, “The Only Three Questions That Count”, ch:2
I think a lot of people have a market crash in mind because they haven’t forgotten what happened in 2008. I am not saying a market crash today is not possible – I am no clairvoyant – but I believe it is unlikely given that people have not yet forgotten about the previous crash and their behavior today is restrained accordingly.
On the flip side, a market correction (10% – 20% drop) is more likely but I don’t change my investing pattern in anticipation of a correction. More on this below.
- We can’t avoid market corrections. These 10 – 20% drops happen regularly in the market. Even in a bull market. The market recovers from them pretty quickly. See this post on how often these double-digit intra-year declines occur – and how to deal with them. In short, you don’t worry about them – they come with the territory. If you or I start reacting to every single market correction by pulling our funds, we won’t stay in the market for too long and likely miss out on future gains.
- Have some dry powder. What if the next market correction turns into an outright market crash? It can happen but no one could know for sure. I don’t think it is likely this year or next – but I could never be certain. When dealing with future, we can only talk about possibilities, not certainties. So what would I do if the market drops 30% to 50%. Two things: (a) I don’t invest money in stocks that I might need in next five years, and (b) I keep some cash (dry powder) in my investment portfolio for the time when bargains are aplenty. I can ride out a bear market without having to sell stocks when they are cheap. And I can also pick up some stocks then at bargain basement prices.
If you don’t believe you have any money that can ride out the next market crash, think again. Markets recover in 3 to 5 years. Do you really need all your savings available to you in less than five years?
You might be thinking your investments are just not big enough to keep any dry powder. But if you are a net saver – someone who is earning more than consuming – you have new money to invest every year. You don’t need to have any dry powder. Every year you will have some new money to invest. When stocks are selling cheap, your dollars will buy you more. In other words, you will be investing in installments instead. You will be fine.