Just last month people were euphoric over stock market highs. Tesla returned massive 50% gains. Shopify broke $700 a share. This week it was gut check time. Stock market around the globe dropped over 10%. It was the fastest correction ever. This seems like 2008 all over again. The question everyone wants to answer is whether this can get worse. Should you get rid of all your stocks? I’m here to tell you why real investors don’t sell during a stock market crash.
Many of the people that are panicking and selling their stocks are not investors. They are short term gamblers. The people who invest in Apple, Shopify and Tesla were all chasing quick gains. These gamblers use the stock market as a casino, most likely because the closest casino is too far to drive to. Real investors understand they are there for the long haul. They realize the real reason to be a shareholder of a company.
History of Stock Market Crashes
Throughout the last couple of decades, the stock market has been subjected to many crashes and corrections. Each time stock market traders react in the same way. Mass panic selling especially at the bottom of the drop. This is the easiest way to lose money. Sell at the bottom!
Many readers here probably haven’t heard of the dotcom market crash in year 2000. A life without Facebook and Instagram? What kind of world is that? Prior to DotCom crash companies like Microsoft and Nortel were flying high. Stories of intern students making $1000USD (that was a lot of money back then) a week and driving in drop top convertibles in California were all the rage. All anyone needed was a company that had a .com web address on the Internet. That’s all it took to get investors to buy shares in the company.
The party ended in the middle of year 2000. Stocks slid for almost a year until the bottom was reached in the middle of 2001. Everyone thought the Internet was dead. There was no money to make on the Internet and all these tech companies were just a sham. In fact, many companies were shams, but we know now that many companies were not. Technology companies thrive in the California valley now making year 2000 seem like a joke.
Many investors sold every stock they owned. Never to return to the stock market every again. This was when the S&P index was only around 900 points. How many grannies and boomers do you talk to that state how dangerous the stock market is. “I lost everything in Nortel”. “Don’t buy stocks! It’s a scam!”. These are the bitter, older generation talking about their own failures and why the stock market never works. They were gamblers, not investors for the long run. And look at what they missed out.
The Financial Crisis
The gamblers and the scared sold off all their stocks, but found better ways to gamble with their money: Real estate. The real stock investors that didn’t sell during the stock market crash continued on their merry way. 8 years later we meet one of the biggest stock market crashes that still resonates today.
At the bottom of the 2000 DotCom crash, investors that just stuck with the S&P 500 index went back up to 1400 point by 2008. That was basically the full recovery of the DotCom bust. Thanks to what we know now, the Great Financial Crisis saw one of the biggest collapses of the American stock market. 50% of the market was wiped out over a matter of months. Those that invested in stocks lost half their net worth. Those that invested in real estate went bankrupt.
The Trump Effect
Believe it or not, having President Trump in office has not always been rosy. Though the president uses the stock market as a proxy for his success, the stock market has not always gone up. The most recent correction in the stock market happened not too long ago.
How fast can you wipe out 20% of the stock market? Try a month in 2018. Everyone was thinking Trump was crazy. The American empire was going to end after a couple of years of his rule. What didn’t happen was the collapse of America. Sorry haters.
All of these actions have the same impact to gamblers and emotional investors. Each of them sold out at the bottom of the stock market crash. The selling intensified and magnified the losses the next preceding shareholder that tried to escape the market. Again, real investors don’t sell during a stock market crash. Those that heed that lesson will always end up better than the one that sold everything.
Softened A Stock Market Crash With A Balanced Portfolio
After reading so much about stock market crashes, you might be hesitant to invest any money in the stock market. However, since the year 2000 the S&P has risen from about 1000 points to 2900 points. For 20 years that is around a 300% gain. Not too shabby if you ask me. Unfortunately, how many people do you know that have actually tripled their money in the stock market? Probably not many.
The reason why most people don’t profit from the stock market is that their emotions get the better of them. Remember what I said? Real investors don’t sell during a stock market crash. We already know that speculators and gamblers trade daily because they are using the stock market as a casino. But that doesn’t mean investors do that.
Investors understand that investing in stocks means long term. It’s exactly the same as a marriage. Till death do you part with your investments. That statement only runs true because the government requires you to liquidate your portfolio after death. The point is, as an investor, the goal is to generate passive income from the investments, not to score a big windfall so you can buy a new Tesla next month.
Don’t Sell, Buy More Stocks After A Market Crash
To really become successful in investing, means to do something most people don’t do when the stock market crashes. You invest more. As Warren Buffer says, “be greedy when others are fearful”. This is really hard to overcome for many people because investing is so emotional. It’s hard to put money into something that has fallen 20% in value because our minds are programmed to only invest in appreciating assets.
When stocks crash, most people think to themselves “I should buy Apple now.” This is the kind of thinking you don’t want to do. The fact is you should not be predicting or timing the market. The question you should be answering is “how do I re-balance my portfolio?” When a significant event happens that puts your original investment thesis (the ratio of stocks to bonds) out of its range then it is time to re-balance.
Example Of How to Re-balance After A Crash
- Imagine a $100K portfolio with $60k allocated to stocks and $40k allocated to bonds
- A 20% market crash happens to take the stocks down to $48K
- At the same time, bonds pop up 2% to $40.8K
- At this point the ratio of stocks to bonds is now 54% to 46%. This is significantly off from the 60% and 40% allocation amount before the crash
So what do you do when the ratio becomes skewed? What if we have no money to invest with? That’s a very easy question to answer. We sell bonds to buy stocks!
- To regain a 60% stock to 40% bond ratio out of an $88.8K portfolio, we need $53.28K in stocks and $35.52K in bonds.
- To get that ratio, sell $5.28K in bonds and buy that exact amount in stocks
Why do we have to re-balance? When the market starts to recover, which it will inevitably do, re-balancing the portfolio actually makes you recover much faster. Math is very funny, when the stock market drops, it takes 11% in appreciation to recover the drop. When the market drops 20%, it takes 25% in appreciation to achieve this. With average returns of only 7-8%, this would take you 3 years to recover from a crash, but by re-balancing you can recover much faster.
As the chart shows, if you re-balance your investment portfolio, after only a single year of of standard 8% gains you would have fully recovered from the crash. On the contrary, if you don’t re-balance your portfolio it would take three years to recover. The reason why this phenomenon occurs is because by re-balancing a portfolio you essentially buy low and sell high. That’s the beauty of removing emotion from investing. You automatically do the right thing.
Can You Emotionally Handle A Stock Market Crash?
A stock market crash is the true test to an investor’s thesis because it shows how well an investor deals with volatility. It’s easy to hold onto stocks when gains of 20-30% occur annually, but what happens when the stock market crashes? Are these same stocks worth holding onto? Can the investor stomach large losses?
Just take a look at the popular FANG stocks to see what the last week’s drop has done to high flyers:
- Apple Stock – down 16.6%
- Facebook – down 11.7%
- Netflix – down 4.6%
- Google – down 12.6%
Some of the most popular individually owned stocks have crashed hard. What this blog advocates as an investment portfolio is to avoid picking individual stocks. It’s the difference between a large drop in stock prices like Apple and having a soft landing.
For instance, let’s take a look at the impact of what the stock market crash did to the performance of the Tangerine Balanced Growth fund. On February 21, 2020 at the start of the week, the fund had a value of $16.79. By the end of this week, February 28, 2020, the price of the fund is $15.67. That’s only a drop of 6.9%. A balanced investment portfolio is not immune to the drops of the stock market, but nowhere near the large drops experienced by Apple and Google.
This is the power of a balanced portfolio consisting of 60% stock and 40% bonds is supposed to do for you. Rather than throwing all your eggs in one basket, a balanced portfolio is there to soften the landing of a stock market crash.
Is The Stock Market Crash Over?
First off it’s impossible to know when the stock market will stabilize. Given the spread of the Covid 19 virus through the other parts of the world, it’s safe to say that the worse is not over yet. So expect further volatility and maybe even sharper drops in the stock market. Will the economy recover from this? Certainly. The virus is serious, but it’s not the Apocalypse. People do recover from Covid 19 and the world will go on.
Another bigger threat to the economic lookout of the economy is what the US Presidential election outcome will be. Expect lots of volatility in the later part of the year too when the markets try to predict who will become the 46th President of America.
So the real question to ask yourself is. Are you a real investor who doesn’t sell during the stock market crash or are you an emotional wreck that worries about your money? Perhaps you require a professional financial planner to re-evaluate your risk tolerance and help you achieve an investment portfolio balance that suits your personality.
If the stock market crash doesn’t scare you at all but gleams in your eyes as a Black Friday sale, then great. More power to you. Keep doing what you’re doing, practice safe hygiene and stay healthy. This virus scare will eventually blow over and you’ll be in a much stronger position afterwards.