Chapter 9
The Big Ugly Event
So far we’ve seen that the stock market is a wonderful wealth-building tool that moves relentlessly upward. Vanguard’s Total Stock Market Index Fund, VTSAX, is the only tool we need to access it.
But we’ve also seen that it is extremely volatile, crashes routinely and most people lose money due to their psychological tendencies. Still, if we toughen up, ride out the turbulence and show a little humility regarding our investing acumen, this is the surest path to riches.
Except……
The Dow Jones Industrial Average 1900 – 2012 Credit: www.stockcharts.com
There, in 1929, is the Big Ugly Event. The Mother of all Stock Market Crashes and the beginning of the Great Depression. Over a two year period, stocks plunged from 391 to 41, losing 90% of their value along the way.
Should you have been unlucky enough to have invested at the peak, your portfolio wouldn’t have fully recovered until the mid-1950s, 26 years later.
Yikes. That’s enough to try the toughest investor.
If you had been buying stocks on margin (that is, with money borrowed from your broker) as was all too common at the time, you would have been completely wiped out. Many speculators were. Fortunes were lost overnight. Never buy stocks on margin.
So what to do? Does the possibility of another Big Ugly Event blow a big enough hole in this idea of “toughen up and ride out the storms” to make it useless? The answer to that has everything to do with your tolerance for risk and your desire to build wealth. There are ways to mitigate the risk and we’ll talk about them later.
For now, let’s step back and consider a few key points regarding The Big Ugly:
1. It would have taken an investor of exceptionally bad luck to have borne the full weight of the crash. You would have had to buy your entire portfolio precisely at the 1929 peak.
Suppose instead you had invested in 1926-27. Looking at our chart this is about halfway up on the climb to the peak. Many, many people were entering the market in these years. Certainly they were destined to lose all their gains, and yet 10 years later, had they held on, they’d be back in positive territory. Although another rough stretch was coming.
Suppose you’d bought at the earlier peak in 1920. You would have taken an immediate hit and recovered five years later. From the collapse in ’29 you’d be back even by 1936. Seven years.
The point is that any given start would have yielded a different outcome and one not as severe as the widely quoted 90% loss, peak to bottom.
2. Suppose you were just out of school and beginning your career in 1929.
Assuming you were in the fortunate 75% that kept their jobs, you would have had decades of opportunities to buy stocks at bargain prices.
Ironically, a crash at the beginning of your investing life is a gift. In fact, any pullback in stock prices is a gift while you are in the process of accumulating your wealth. It allows you to buy more shares for your dollars, on sale if you will.
3. Suppose in 1929 you were retired with a million dollars. By 1932 your portfolio is down 90%, to $100,000. A terrible hit for sure. But remember, the Depression was a deflationary event. That means the prices of goods and services fell dramatically, along with those of stocks. And that means your $100,000, while no longer a million, now had far more buying power than that same amount did pre-crash. Plus, it was poised to grow rather sharply from this low.
4. The Big Ugly Event has happened only once in the last 115 years. Longer actually, but that’s how far back our DJIA data goes. We haven’t had another in 86 years. Some even argue that with the controls put in place since 1929 it is unlikely we ever will again. While we can’t be sure of that, we do know these are extremely rare events.
5. In 2008 we came right to the edge of the abyss. Closer I think than most folks fully appreciate. But we didn’t tumble over. This I find encouraging.
What is not so encouraging is that a deflationary depression like that of 1929 is only one of the two possible economic disasters that can destroy
wealth on a major scale.
The other is Hyperinflation.
Here in the U.S., we haven’t had to deal with this monster since the Revolutionary War way back in 1776. But it destroyed Zimbabwe’s economy as recently as 2008. Hungary had the worst case of it in history when in July 1946, the peak inflation rate reached 41.9 quadrillion percent, and many credit the German hyperinflation of the 1920s with ushering the Nazis to power in the 1930s.
Hyperinflation is very bad news—every bit as destructive as deflation— and it is exactly what it sounds like: Inflation running out of control.
A little inflation can be a very healthy thing for an economy. It allows for prices and wages to expand. It keeps the economic wheels greased and running smoothly. It is the antidote to looming deflationary depressions.
In a deflationary environment, delayed buying decisions are rewarded. If you were considering a new house in 2009-13 you would have noticed that prices were dropping, along with mortgage interest rates. Recognizing you could get both for less later, you waited. If enough potential buyers joined you, demand would drop pulling prices and rates down further. Delay is rewarded and action is punished. Too much of this and the market slips into a deadly spiral of crashing prices.
But during periods of inflation, anything you want to buy will cost more tomorrow than today. You have an incentive to buy that house (or car or appliance or loaf of bread) today and beat the price increase. Delay is punished with higher prices later and action now is rewarded. Buyers become ever more motivated. Sellers become ever more reluctant. Too much of this and the market slips into a deadly spiral of increasingly worthless currency people are desperate to exchange for goods.
Governments love a little inflation. They can add money to the system, keep the economy humming and not have to raise taxes or cut spending to do it. In fact, it is sometimes called “the hidden tax” because it erodes the buying power of our currency. It also allows debtors, like the government, to pay back their creditors with “cheaper dollars.”
The good news for our VTSAX wealth-building strategy (which we’ll discuss in depth in the next few chapters) is that stocks are a pretty good inflation hedge. As we’ve discussed, in owning stocks we own businesses.
These businesses have assets and create products. The value of those rise with inflation, providing a hedge against the falling value of the currency.
This is especially true in times of low to moderate inflation.
The decision every investor must make is how much risk to accept in the wealth-building process. Looking at the past 100+ years, you have to ask yourself whether it makes sense to focus on the Big Ugly or to invest in the relentless rise that has dominated history.
None of this is to say that Big Ugly Events are not very scary and destructive things. But they are rare and in the context of our overriding approach (spend less than you earn—invest the surplus—avoid debt), they are survivable.
In the next few chapters we’ll look at specific investments to build and protect your wealth. As I promised in Part I, you won’t believe how simple it is.