Earlier in the year I wrote about how to get a good deal on stocks. The post was called “happy hour at the stock market.” A quick summary of the article is as follows:
- Stocks can be expensive and stocks can be cheap.
- It is in your best interest to buy when stocks are cheap (more bang for your buck).
- On top of that, it is in your best interest to invest your money immediately (lump sum investing) versus spreading your investments out over a long time (dollar cost averaging) because the stock market almost always goes up.
- In really expensive markets, like in the summer of 2014, it could make sense to dollar-cost average or implement some timing strategies to limit downside risk.
I’m writing this update because I’ve changed my mind a little bit about number 4. The catalyst to this mind change was Mr. Money Mustache’s article from earlier in the month, “How to Invest in an Overvalued Market.” His thoughts on the matter can be summed up in one quote:
The best time to invest in stocks was long ago. The second best time is today. The basic reason is that on average, the stock market always goes up, and it pays you dividends all the while.
I’m not following MMM, an albeit outstanding financial role model, blindly here. Before reading his article, I had recently come across a NY Times article that also examined the DCA vs. lump sum investing question titled, “Hesitating on the High Board of Investing.” They came out in favor of lump sum investing too.
The interesting thing about the article for me though was that it completely obliterated all my assumptions about how long it takes to recover from a stock market crash. You hear things like, “it took a quarter of a century to recover from the stock market crash during the great depression.” More recently we’ve seen headlines about the Dow Jones finally climbing to record levels again, more than 5 years after the recession and 2008 stock market crash.
Those kind of headlines lead people to believe that having money in the market during a major stock crash is a major catastrophe that is really hard to recover from, but the reality of the situation is much different. These headlines miss two key factors:
- Inflation / deflation (purchasing power)
- Dividend reinvestment
Stock market averages are just nominal figures. They don’t reflect the true value of your money. For example, the average dividend yield of the S&P 500 is about 4.5%, but those 4.5% dividend “returns” don’t get reflected in nominal market indices. And if you’re reinvesting dividends during a downturn, you’re getting a lot of stocks at clearance sale prices (really good value).
Nominal prices also don’t reflect what is going on with inflation. If inflation grows at 8% and the stock market grows at 12%, your real return is actually only 4% because that 12% gain is offset by an 8% increase in prices. See this article for more details on the purchasing power side of things, but the basic idea is that sometimes downturns are accompanied by slow inflation or even deflation, as was the case in the Great Depression. For example, if the market crashed by 10% in one year but there was 5% deflation that same year, then you truly would have only lost 5% in real purchasing power.
That is all good and well, but the thing that really blew my mind in the New York Times article was that the longest it has ever taken the stock market to recover from a crash is a little over 3 years, and that was after the Great Depression. A little over 3 years to recover when the market dropped almost 70%!!! Holy sh*t! And then for the 2008 crash, where the market lost over 40%, it would have taken a little less than 2 years to recover your money. Damn son, where’d you find this!?!
Compare the actual recovery time of less than 2 years to the nominal recovery time of over 4 years in the 2008 crash, or even better compare the 3.25 year Great Depression recovery to the supposed quarter of a century number that gets volleyed about. Things aren’t always what they seem…
What all this tells me is that a long-term investor like myself is much better off worrying about other things. Dividends and inflation/deflation help a portfolio bounce back a lot quicker than nominal prices would imply. The worst case scenario (at least by historical standards) is that your portfolio will be in the red for a maximum of 3 years. If you’re not retiring in 3 years, who cares? Keep shoveling that money in as quick as you can get it.
Yes, it would be nice to time the market perfectly and buy at the bottom, right after a major correction or crash, but the reality is that it’s much harder to time that window because of opportunity costs (you miss out on growth and dividends while waiting for the next crash) and a deceptively quick-rebounding stock market. No doubt, however, if the market does crash on your watch, throw all the free cash you can at it, because it won’t be on sale for long (do I hear a wedding ring sale??).
That’s my philosophy at least. I’m not planning to sit on cash for any period of time going forward… I’ve got much longer than 3 years until I retire, and I’ve got more useful stuff to worry about. Cash in low-interest money market or savings accounts isn’t doing me any favors. Like MMM says, let those one dollar soldiers do the work for you!
Onward and upward mates!
I’ve put together a very crude chart that estimates how long it takes to recover from various levels of stock market crashes. I’m using the two known data points of the Great Depression and the Great Recession (per the NY Times article linked above) and extrapolating from there, assuming a simple linear relationship.
The known data points are in green, the estimates are in purple. For the long-term passive investor such as myself, the point is that we recover surprisingly quick from stock market crashes… so don’t worry; be happy.
For the active investor, the chart paints a little different picture. It shows how big of a stock market crash would be necessary to make market-timing a successful strategy. For example, if I’ve been holding $10,000 in my savings account for 2 years, waiting for the next market drop, stock prices would need to drop by almost 50% just to make me even.
If someone does have strong opinions and wants to try to time the market this is a very loose guide to how long it might be rational to wait. For passive investors, this should be more of a Xanax pill for market jitters… just sit back, keep investing money, and let all your anxieties slip away…