Where To Put Your Money When The Market Is Tanking
“Dow endures worst point drop in history!” “US braces for soaring unemployment.” “S&P rises on optimism of slowing rate of coronavirus cases.” These are a few of the conflicting and fear-inducing headlines we’ve all seen regarding the recent decline in the stock market. As financial markets continue to unravel, we will see our fair share of optimists and doomsdayers in the news. Throughout all of this, you may be sitting at home reading the papers and wondering if now is the time to finally open that trading account. I thought it would be beneficial to provide some simple advice for people wondering how to enter the stock market for the first time or how to manage their current portfolio. It is daunting to watch the news and see the market’s rapid decline, but it is important to think about investing as a long-term strategy and stray away from making impulsive, short-term decisions. The most successful investment portfolios are built on a disciplined and proactive investment philosophy rather than one that is emotional and reactive. While it is not the sexiest approach, investing small amounts consistently over a long period of time and not selling during market downturns (like the one we are experiencing currently) has provided the least risky and most superior investment returns time and time again. I will structure this series in three parts based on the investing questions I receive, which fall into one of three categories:
1.) How much should I invest?
2.) What should I invest in?
3.) How do I actually invest?
A Brief History of Stock Market Crashes: Dismantling Misconceptions #1
Before diving into a discussion on how much money to invest, I will explain why stock market crashes are the best time to buy. In the United States, there have been four noteworthy stock market crashes, explained below:
The Great Depression — The first known stock market crash began in 1929. The booming economy of the 1920's fueled overconfidence among consumers, which led to those consumers taking on excess amounts of debt to purchase big-ticket items like homes. Eventually, the economy ran out of steam and lower wages combined with higher unemployment resulted in major debt defaults, panic-selling, and an eventual collapse of the stock market. Stock prices continued to fall, leading to the period known as The Great Depression. While the depression lasted until 1939, the stock market began its recovery in 1933 and from the beginning of 1933–1937 returned a cumulative 155%.
Black Monday — The stock market crash of 1987, known as “Black Monday” was different from the crash of 1929 in that it was quicker and it was not based on a widespread deterioration of the economy. On October 19, 1987 the stock market lost ~23%, the largest one day percentage drop at the time. There is no consensus for what exactly caused the market crash but a combination of the introduction of computerized trading, rising interest rates & heightened tensions in the Persian Gulf have all been cited as reasons. What’s more important is that the stock market bounced back, gaining another 290% from Oct. 1987 to 1999.
The “Dot Com Crash” — The proliferation of the internet and new technology companies precipitated the stock market crash of 2000, a.k.a “The Dot Com Crash.” This period of massive growth led to a flurry of new tech companies being created, many of them unprofitable. People dumped millions of dollars into these speculative companies in hopes that they would one day become profitable. That proved to be untrue as many of these companies went bankrupt leading to massive losses in the market. This crash took a couple of years to recover, finally bouncing back in 2003. Stocks continued to return another 55% from 2003–2007.
The Great Recession — Most of us are familiar with the most recent downturn as “The Great Recession” of 2008. The booming housing market of the 2000's led to an overabundance of outstanding mortgage debt. For example, people were able to take out jumbo mortgages on multiple homes with little to no proof of income. Eventually, people were unable to meet their mortgage payments, leading to a crash in housing prices, and ultimately a crash of the financial system, banks included. Once the dust had settled, the S&P lost almost 40% of its value in 2008. After a series of bailouts and economic stimulus packages, the housing market began to recover and the stock market boomed another 141% from the bottom in 2008 until the beginning of 2020.
So, how do you manage your portfolio during a crisis? The same way you would otherwise. You should be able to spot the common theme for yourself. Historically, selling stocks during market downturns has proven to be a bad decision, whereas buying during those downturns has proven effective.
Dismantling Misconceptions #2
When you hear the term ‘Millionaire,’ what image comes to mind? Probably someone who lives in a mega-mansion, drives luxury cars and wears the most expensive clothes. The book “The Millionaire Next Door”, by Thomas J. Stanley and William D. Danko challenges our societal perceptions of the “average” millionaire and is based on 40 years worth of empirical studies, focus groups, and surveys of households with at least $1 million in net worth to gain a better understanding of their habits and behaviors toward money. Stanley and Danko explore the key concepts of personal financial offense (how much money one brings in through a bi-weekly paycheck from their job for example) and defense (how much money one has left over in savings).
The natural assumption is that higher offense (i.e. higher income) necessarily leads to higher defense (higher savings). However, that has proved to be untrue in many cases. Individual attitudes and behaviors around spending and saving had a greater significance than income level. Often, people feel discouraged from investing because they don’t identify with their preconceived notions of a “Millionaire.” They don’t think they make enough money or have enough disposable income. This is a huge misconception that you need not have! I have gone through why you shouldn’t think along those lines; here is how you should think and two essential strategies for investment.
How much should I invest? The 50/30/20 Rule
There is no definitive dollar amount for how much one should invest. Investing (even small amounts) based on your financial situation as well as sticking to your goals, will yield greater results over time than placing large sums of money into the next “hot stock”. Instead of looking for a hard dollar amount, invest an amount of money that you will not need to touch for a prolonged period of time (meaning years). A commonly cited guideline to follow is the 50/30/20 rule, which states that 50% of your income should be spent on needs, 30% on wants, and 20% for saving/investing. This means that everyone can and should start investing regardless of their income, whether that amount is $1,000 or only $100 a month. More important than the amount invested is maintaining discipline in your investment approach and not pulling out of the market during downturns. Stanley and Danko’s book explores these concepts in more detail.
So, be encouraged to get started with whatever amount you are comfortable with! If you continue along with discipline and patience, you will reap the financial reward over a long period of time.
The Power of Compounding Interest
It is rumored that Albert Einstein once proclaimed, “compound interest is the most powerful force in the universe.”
This quote certainly holds true for investing in the stock market. The S&P 500 Index, which comprises the largest U.S. companies by market-cap and is the benchmark for the overall health of the U.S. stock market, has returned 10% yearly on average since its inception in 1926. That’s right. Even through all of the downturns during some of the worst periods in history for the market (The Great Depression of the 1920's and 30's, Black Monday of 1987, the tech bubble crash of the early 2000's and the Great Recession of 2008) the S&P has bounced back resiliently over the long-term to return 10% per year. For reference, the highest interest savings accounts nowadays only generate around 1.7%. Let’s put this into practice in real dollar terms.
For the purposes of this example, I will assume that all invested funds are not withdrawn, all dividends are reinvested and I will not account for inflation. Let’s say that one contributes $1,000 into the S&P 500 right now and makes a monthly investment of $100 from their paycheck. Assuming the historical 10% S&P yearly average, in 5 years that investment will be worth ~$9,200 and ~$23,000 by year 10. If one remains consistent, over a period of 20 years that investment will be worth ~$80,000 and in 30 years one will have amassed ~$247,000. How is this result possible from such a seemingly minuscule initial investment? The answer is compound interest. Say you have $1,000 compounding at the 10% number we mentioned earlier. After one period we have $1,100 ($1,000 x 10%). Now, the next 10% is being compounded on the $1,100 instead of the initial $1,000. In the next few periods we end up with $1,210, then $1,331, $1,464 and so forth. With simple interest, you only earn interest on the amount of your initial investment (The $1,000). However, with compound interest you earn more money in each period as the value of the investment increases. Simply put you earn gains on top of your gains, which increases the value of your investment much quicker. This is why not pulling out of the market in fear is key, the earnings you make on your investment are being reinvested to gain additional earnings on top of those earnings, as shown below:
My goal with these articles is to help make an esoteric subject for most people a bit more straightforward. Hopefully these tidbits of information can begin to provide you with the knowledge and the confidence required to put your money to work!
