About the Author
David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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*This article was originally published on 1 Oct 2018. I think it serves as an important reminder given the recent volatility and market sell-offs in response to the coronavirus sell-off of March 2020.
Black Monday….October 19, 1987, the day the market crashed. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already sustained significant declines. The Dow Jones Industrial Average (DJIA) fell exactly 508 points; roughly 22.61% of its total value. The Black Monday decline was, and currently remains, the largest one-day percentage decline in the DJIA history. A terrible day in the market to be sure.
A bit closer to our memory is the crash of 2008. The financial crisis of 2008 is considered by many economists to have been the worst financial crisis since the Great Depression. The root cause of the crisis is complicated; sub-prime mortgage lending, excessive risk taking by banks and financial institutions, government bailouts, and a troubling long-term recession are all part of the equation. The DJIA fell by more than 50% over a period of 17 months from a high of over 14,000 to a low of 6,600 during that particular nasty crisis. Dramatic is putting it mildly. You likely remember the fear and uncertainty that gripped much of world. Every day it seemed like a greater calamity was afoot and you couldn't escape it. These crisis highlight the very worst of the market and remind us why investing is seemingly such a risky endeavor.
What are we to make of this risk?
Yet, here we are today, watching what is approaching the longest bull market (upswing) in history. Stocks have continued their relentless climb for the past 114 months since the fall of 2008. It is quite frankly making people nervous. We are seemingly entering new territory and we are being told stocks are not supposed to grow the way they have. The media is predicting doom and gloom again. There is talk of an asset bubble, that real estate is too expensive, that foreign markets are flooding the U.S. economy, and that we are doomed for a sell off. Just take a look at some of these quotes:
“Take your money and run.' Investor David Tice warns on 'pretty dangerous' stock market” (CNBC).
Or this one
“Everybody thinks the market is overvalued,” said Jerome L. Dodson, the founder and president of Parnassus Investments. “So do I. I’m expecting a correction.” (NYTimes)
And this one
“Meet the bears predicting stock market doom” (CNN)
The fact is, nobody knows what the market will do. David Tice made his prediction back in April 2018. Jerome Dodson, back in January 2018. And the bears…October of 2017. [Since then, the market would continue to rise with the DJIA gaining a record high of 29,551.42 set on Feb. 12, 2020.]
Doom and gloom predictions sell. That is why you will always see naysayers in the newspaper and television programming. If you get caught up in what other's are saying, you will likely talk yourself into a bad decision. I would encourage you to tune out the hype and turn off the TV. Investing in the stock market is not for the faint of heart, but it is especially important in order to achieve a life of dignity when we approach our golden years.
Here’s the secret, stocks are really not all that scary if you will just stop taking a soda straw view of the market. Ever looked through a soda straw? What do you see? Only a narrow view of what is in front of you. Most of us are guilty of a soda straw mentality when it comes to investing. We focus on the news of the day and are heavily influenced when we see the market drop. Throw away the straw and focus on the totality of what you are trying to achieve.
Why We Must Invest in Stocks
We know that America has a savings problem. Our fellow hardworking neighbors are only saving 6.7 percent of their income. Pensions have mostly gone away. Social Security will only ever provide you a portion of what is necessary to live a full and dignified retirement. Only 54% of our working population is taking advantage of the stock market and only 10 percent of the population owns 84 percent of the entire market. Something has to change, and I believe you and I can be that change.
Stocks are Risky...So What!
Let’s define risk. One definition of risk is the loss of capital. If I invest in a stock, and the stock goes down and doesn’t rebound, or the company I invest in goes out of business, or the founder of the company decides to smoke pot on TV and then gets investigated for improper tweeting, then yes, that is a legitimate risk and you may indeed lose your hard earned capital. This type of risk is what academics call a “specific risk” or “individual-stock risk”.
There is a way to mitigate this risk. We mitigate it through diversification. By purchasing a mutual fund or Exchange Traded Fund (ETF) we are essentially spreading the risk of a company failing out among the hundreds or thousands of other companies we are invested in. The loss associated with that individual stock isn't enough to drag down our portfolio.
However, an ETF or mutual fund won't keep the market from going up and down. We know stocks are going to go up and down and this phenomenon has a name called volatility. Volatility refers to the amount of uncertainty or risk related to the size of changes in a security's value; meaning we don't know what the heck the market is going to do in the short-term and there is a risk that the value of the stock could substantially change for the better or the worse. A lower volatility means that a security's value does not fluctuate dramatically, and tends to be steadier. A higher volatility conversely means there is a lot of fluctuation between the lows and the highs. Volatility is what scares of most novice investors.
But, volatility is often the trade-off you often get for the higher returns of stocks. The more volatility in an investment, the more risk, the more risk the higher premium is paid to an investor willing to take that risk; there is a strong correlation between risk and reward. Want to earn a higher return on your investment? Invest in a security (eg: a stock) that has more risk and likely higher volatility. But remember, while these temporary market swings are a part of investing, how you react to them will determine your chances of earning that higher reward/return.
There is a difference between investment returns and investor returns. Volatility pushes investors to do things they shouldn’t do, like confuse a short-term market drop with a long-term fundamental problem with the company whose shares were purchased and then cash out of the market. Volatility often leads a novice investor to poor decision-making which in turn leads to higher costs (trading fees), lower returns (poor market timing), and a shortfall in our investing goals.
A savvy investor knows there is a difference between a fluctuation and a loss. Volatility is simply a fluctuation. The day-to-day changes in an individual stock or a bucket of stocks like a mutual fund, are temporary in nature. They will go up, and they will go down, that much is certain. What you are buying when you invest is actually a share of a company or companies. If you don’t sell your share, you haven’t actually lost anything. Those that panic when they see the share price fall and end up selling, they actually are losing something. Those long-term investors who don't lose their vision for the future will likely be just fine in the long-run.
In fact, you should be excited about the opportunity a fall in share price presents a long-term investor. A fall in share prices creates the opportunity to purchase more shares at a steeply discounted rate! Most Bear Markets (market drop) have averaged 13 months. Unless you are a few years within retirement, the stalwart among us will actually be cheering every time the market drops and buy more stocks while the prices are low. If history is a guide, the subsequent Bull Market (market gain) will likely last the next 97 months!
The Risk in a Loss of Purchasing Power
There is a more insidious risk you should be worried about than the possibility of a stock going down or the market crashing. That is the risk of a loss of purchasing power for the money you already have saved. Because of our monetary policy we know that inflation will likely double and perhaps triple consumer prices during a typical 25 year retirement. Risk is not just capital loss but rather as Nick Murray puts it, “the extinction of an investor’s purchasing power within his or her lifetime.” Thus, risk is not losing one’s capital, rather it is outliving it!
Murray defines risk for what it really is, not volatility, but permanent loss and outliving your money. Volatility is temporary and passes with time, but the loss of purchasing power is ever present. To increase the purchasing power of your money you must achieve a “positive long-term return net of inflation and taxes” and stocks are one of the few ways to achieve this positive long-term return.
Stocks produce about twice the return of bonds and three times the return of cash (T-bills and money market). This is especially poignant when you compare stock returns to bonds when you account for inflation. Inflation, measured by the Consumer Pricing Index, averages over 3% historically. Taking inflation into account we see that stocks outpace inflation two to one, and produce about three times the return of bonds.
Looking at the historic returns a few things should pop out at you. Stocks are the only way to achieve a “positive long-term return net of inflation and taxes”. Bonds will likely only break-even, and cash will continue to lose value over time. Bonds do have an important role to play in your portfolio. Bonds are defensive in nature, and are designed to lower volatility, but bonds will never be enough to outgrow inflation on their own. Now that we know stocks are the only way to achieve our long-term savings goal we should look closer at the positive outlook of stocks.
A Positive Market Outlook
Why this rosy outlook? Because while we don’t know the future, our best guess is it will look a lot like the past in the macro view. While we acknowledge that past performance is no guarantee of future outcomes, we can believe that the expansion and growth of economies across the globe will create the demand for capital, and the investment of capital will likely bring positive returns to the investor over time. As a result, we can believe the stock market will likely keep going up in the macro sense. It won’t go up each day, maybe not each week, or each month. It may even stay down for years at a time. But it will keep going up. If you can constantly invest in stocks month after month, year after year, for your entire life, wealth will become inevitable. Don’t believe me? Take a look at this chart that illustrates the growth of a dollar invested over time.
While sequence of returns risk is still present, the basic premise of a growing market over time is still relevant. Those two blips I highlighted….those are the crash of 1987 and 2008. Dramatic for those who lived through them, but not nearly as significant for those that kept their cool, held on to their shares (and maybe even bought more while they were on sale) and kept investing all the way through the peaks and the valleys.
Don’t avoid stocks. Stocks are the only way you can earn enough on your investment to counter the deleterious effect of inflation. Most importantly, stop looking through the soda straw and acknowledge that the market will continue to go up and down in the short-run, despite your best efforts to control anything. If you take a long-term outlook on investing you will understand that you must stay in the market to be in the position to take advantage what the market offers. The DJIA fell to 1,738.74 points on Black Monday; today it is at 26,458.31 points. That is a heck of a ride.