Chapter 6
There’s a major market crash
coming!!!! and even famous
economists can’t save you
One day a few years back, I found myself feeling a bit testy. I had just finished an article in a popular money magazine and reading this particular magazine is, in and of itself, enough to make me testy.
This particular article featured an interview with a famous economist and finance professor at an equally famous and prestigious university. There were impressive photos of the good professor looking serious and imposing.
To begin Part II of our financial journey together, I’m going to tell you some of what he said and why he’s wrong. It is typical of the “common wisdom” you’ll come across outside this book and in exploring it together we’ll touch on some key subjects we’ll examine in detail in later chapters.
Oh, and that major market crash that’s coming? Don’t worry. I’m also going to tell you why it doesn’t matter.
First, in fairness to the famous economist, I have no quarrel with most of his ideas. Where I do, it is possible the good folks at the magazine didn’t quite get it right. Perhaps they simply didn’t place the emphasis correctly.
Maybe someday this economist and I will have a few laughs over a cup of coffee about it. Or not.
In the interview the professor contends that the long-held theory of efficient markets—which says existing share prices almost instantly incorporate and reflect all relevant information—is morphing into what he calls the “adaptive markets hypothesis.” The idea is that with new trading technologies the market has become faster moving and more volatile. That means greater risk. True enough and so far so good.
But he goes on to say this means “buy and hold investing doesn’t work anymore.” The magazine interviewer then points out, and good for him, that even during the “lost decade” of the 2000s, the buy and hold strategy of stock investing would have returned 4%.
The professor responds: “Think about how that person earned 4%. He lost 30%, saw a big bounce back, and so on, and the compound rate of return….was 4%. But most investors did not wait for the dust to settle.
After the first 25% loss, they probably reduced their holdings, and only got part way back in after the market somewhat recovered. It’s human behavior.”
Hold the bloody phone! Correct premise, wrong conclusion. We’ll come back to this in a moment.
Magazine: “So what choice do I have instead?”
Professor: “We’re in an awkward period of our industry where we haven’t developed good alternatives. Your best bet is to hold a variety of mutual funds that have relatively low fees and try to manage the volatility within a reasonable range. You should be diversified not just with stocks and bonds but across the entire spectrum of investment opportunities: stocks, bonds, currencies, commodities, and domestically and internationally.”
Magazine: “Does the government have a role in preventing these crises?”
Professor: “It’s not possible to prevent financial crises.”
In the online comments for the article, a reader named Patrick nailed the flaw: “So, markets are efficient except when they’re not. And buy and hold doesn’t work because most people don’t stick to it at the wrong time. OK wisdom, but is this news?” Gold star, Patrick.
Worse still is the professor’s recommendation to hold “the entire spectrum of investment opportunities.” This is his solution to dealing with the new investing world his “adaptive markets hypothesis” implies?
Seems odd, since he contends “buy and hold” no longer works, to suggest investors buy and hold nearly every asset class imaginable. Huh?
Let’s accept the professor’s premise that markets have gotten more volatile and will likely stay that way. I’m not sure I buy it, but OK, he’s the credentialed economist. We can also agree that the typical investor is prone to panic and poor decision-making, especially when all the cable news gurus are lining up on window ledges. We certainly agree that it is not possible to prevent financial crises. More are headed our way.
So the question that matters most is: how do we best deal with it?
The professor (and many like him) says:
Treat the symptoms.
He defaults to the all too common canard of broad asset allocation. He would have us invest in everything and hope a couple of those puppies pull through. To do this properly would require a ton of work. You would need to understand all the various asset classes, decide what percentage to hold of each and choose how to own them. Once you did that you’d need to track them, rebalancing as necessary. The result of all of this effort is to guarantee sub-par performance over time while offering the slim hope of increased security. I am reminded of the quote: “Those who would trade liberty for security deserve neither.” I say:
Toughen up cupcake and cure your bad behavior.
This means you must recognize the counterproductive psychology that causes bad investment decisions—such as panic selling—and correct it in yourself. In doing so, your investments will be far simpler and your results far stronger.
To start you need to understand a few things about the stock market:
1. Market crashes are to be expected.
What happened in 2008 was not something unheard of. It has happened before and it will happen again. And again. In the 40 odd years I’ve been investing we’ve had:
The great recession of 1974-75.
The massive inflation of the late 1970s and early 1980s. Raise your hand if you remember WIN buttons (Whip Inflation Now).
Mortgage rates were pushing 20%. You could buy 10-year Treasury Notes paying 15% or more.
The now infamous 1979 Business Week cover: “The Death of Equities” which, as it turned out, marked the coming of the greatest bull market of all time.
The Crash of 1987, including Black Monday, the biggest one day drop in history. Brokers were literally on the window ledges and
more than a couple took the leap.
The recession of the early 1990s.
The Tech Crash of the late 1990s.
9/11.
And that little dust-up in 2008.
2. The market always recovers. Always. And, if someday it really doesn’t, no investment will be safe and none of this financial stuff will matter anyway.
4 4 In 1974 the Dow closed at 616.At the end of 2014 it was 17,823.Over
that 40 year period (January 1975 - January 2015) it grew, with dividends 1 reinvested, at an annualized rate of 11.9%.If you had invested $1,000 and 2 just let it ride, it would have grown to $89,790as 2015 dawned. An impressive result through all those disasters above.
All you would have had to do was toughen up and let it ride. Take a moment and let that sink in.
Everybody makes money when the market is rising. But what determines whether it will make you wealthy or leave you bleeding on the side of the road is what you do during the times it is collapsing.
3. The market always goes up. Always. Bet no one’s told you that before.
But it’s true. Understand this is not to say it is a smooth ride. It’s not. It is most often a wild and rocky road. But it always, and I mean always, goes up. Not every year. Not every month. Not every week and certainly not every day. But take a moment and look again at the chart of the stock market in the last chapter. The trend is relentlessly, through disaster after disaster, up.
4. The market is the single best performing investment class over time, bar none.
5. The next 10, 20, 30, 40, 50 years will have just as many collapses, recessions and disasters as in the past. Like the good Professor says, it’s not possible to prevent them. Every time this happens your investments will take a hit. Every time it will be scary as hell. Every time all the smart guys will be screaming: Sell!! And every time only those few with enough nerve will stay the course and prosper.
6. This is why you have to toughen up, learn to ignore the noise and ride out the storm; adding still more money to your investments as you go.
7. To be strong enough to stay the course you need to know these bad things are coming—not only intellectually but on an emotional level as well. You need to know this deep in your gut. They will happen. They will hurt. But like blizzards in winter they should never be a surprise. And, unless you panic, they won’t matter.
8. There’s a major market crash coming!! And there’ll be another after that!! What wonderful buying opportunities they’ll be.
I tell my 24-year-old that during her 60-70 odd years of being an investor, she can expect to see 2008 level financial meltdowns every 25 years or so. That’s 2-3 of these economic “end of the world” events coming her, and your, way. Smaller collapses will occur even more often.
The thing is, they are never the end of the world. They are part of the process. So is all the panic that surrounds them. Don’t worry. The world isn’t going to end on our watch. It is hubris to think it will.
Of course, over those same years she’s going to see several major bull markets as well. Some will rage beyond all reason, along with the hype that will surround them.
When those occur, the financial media will declare “this time it’s different” with all the same confidence as when they claimed the end had come. In this too they will be wrong.
In the next few chapters, we’ll discuss why the market always goes up, and I’ll tell you exactly how to invest at each stage of your life, wind up rich and stay that way. You won’t believe how simple it is. But yer gonna have to be tough.