As I write this article on the morning of Aug. 24th, the Dow just opened down over 1,000 points and CNBC is going crazy with prognosticators predicting what the market is going to do next. This is great entertainment, but it shouldn’t guide you as an investor.
No one can consistently and continuously predict fluctuations in the markets. (Note how CNBC never keeps a running scorecard of its talking heads’ market predictions — it would likely embarrass them.)
You Should Not Be Focused On Variables Beyond Your Control
Moreover, you as a prudent investor shouldn’t be trying to predict market fluctuations, nor should a sound financial plan be affected by them. You cannot control what the market does, and you should not be focused on variables beyond your control.
Instead, you should only be focused on variables you can control. Any historian of the market knows it continuously and repeatedly goes through cycles of getting overheated followed by massive corrections.
The stock market will most assuredly continue its volatile cycles of exuberance and crashes because emotional human participants are what drive markets. Especially amusing is the market history of the tulip mania during the 1600s when, for a short time, a single tulip bulb sold for the equivalent of several years’ salary of a skilled craftsman.
There was also a period during our recent history, in the 1990s, when investors began to believe the stock market had entered a “new era” and would forever continue its double-digit upward climb because of the new Internet economy where profits didn’t matter. Most of those believers finally came back to reality after the crashes of 2000-02 and 2008.
A Sound Financial Plan Is Prepared for Volatility and Crashes
Your job as an investor (or your advisor’s job) is to craft a fundamentally sound financial plan that is prepared for market volatility and market declines. If the success of your financial plan and financial well-being are dependent on what the market does this year or even during the next three to five years, then you have a bad plan.
Let me repeat that point another way, because it’s the most critical piece of this post: The success of your financial plan should not depend on what the market does this year or even during the next three to five years. If it does, then you have a bad plan.
The statistics from our past three major bear markets prove this point. I will get into the details of those in a minute.
I am consistently surprised by the number of people nearing retirement I meet with that have practically all of their retirement savings exposed to market risk. When I ask them why their entire portfolio is exposed to the market when they know they’ll need some of this money in just a few years, they tell me they don’t want to miss out on a big run-up in the market.
When I ask them what would happen to their retirement plans if instead the market suffered a 30% decline, a typical response is they don’t plan on that happening. As politely as I can, I try to explain that 1) the market doesn’t care about your plans, and 2) the market doesn’t pre-announce a decline—you’re typically in the middle of it before you realize it.
Lessons From the Past Three Major Bear Markets
Let’s take a look at the major bear markets of 1973-74, 2000-02, and 2008, and the lessons you should take away from those. First let’s examine the important statistics from those three bear markets.
Crash of 1973-74
One dollar invested in the S&P 500 at the end of 1972 fell to about $0.63 by the end of 1974, a two-year drop of 37%. (Note each of these examples assumes you reinvested dividends. Without dividends, your declines would have been even worse.) It was not until six years later in 1978 that the market permanently restored your dollar back to the break-even point and started growing it.
Crash of 2000-02
If you invested $1 in the S&P 500 at the end of 1999, it fell to about $0.62 by the end of 2002, a three-year total decline of 38%. Your dollar briefly got back above break-even in 2006-07 but fell significantly again after the crash of 2008. It was not until 2010 (10 years later!) that your dollar invested at the end of 1999 permanently made it above break-even (so far, anyway).
Crash of 2008
Finally, $1 invested in the S&P 500 at the end of 2007 fell to about $0.63 by the end of 2008, a decline of 37%, and it was not until five years later in 2012 that you recovered that dollar and stayed above break-even.
What History Tells Us
The first number that jumps out at me in these three major bear markets is the statistical irony that the total drop in each of these three events was 37% to 38%. That means if you had retirement assets of $100,000 invested in the market heading into each of these three bear markets you saw them decline to about $62,000 before they started increasing again.
Most investors can’t emotionally stomach that kind of drop in their account, even if they say they can. That’s why panicked selling occurs.
The second number that jumps out to me is even more important — the number of years it took your dollar to get back to break-even. After each of these three events it was at least five years!
If you’re in retirement or nearing retirement, you don’t have five years to wait for your dollar to get back to break-even. Otherwise you’ll be putting those retirement plans on hold because of poor planning, which many investors had to do after the 2000 and 2008 crashes.
So what should you, the investor, learn and apply from these three bear markets? It depends on how many years you are from your retirement goal.
If You’re More Than 10 Years Away From Retirement . . .
If you’re just starting out or mid-career and more than 10 years from retirement, then you should welcome with open arms a crash in the market. At this stage of your career you should be a net saver, and a crash gives you a great opportunity to dollar-cost average purchases into the market at lower prices (i.e., think in terms of continuous bargain shopping on Black Friday).
Those lower purchase prices will eventually boost your long-term gains. For example, investors who courageously kept buying throughout the bear market of 2008 have seen those purchases more than double in just the past few years.
If You’re Within Five Years of Retirement . . .
If you’re planning to retire within the next five years, then the data from these three bear markets overwhelmingly tell us that you should consider having at least your first five years of projected retirement withdrawals protected from downside risk.
If you don’t, then the history of bear markets tells us your retirement plan consists of crossing your fingers and hoping the market keeps going up during your last few years heading into your retirement. That’s not a plan.
Hope is useful in many aspects of life, but not in investing. In investing and retirement, you need peace of mind. That requires certainty with a solid plan.
You can protect the necessary portion of your assets in a number of ways, including options that still give you some upward potential, but that is a topic for another day. The important point here is you need to give some thought to how much of your assets are protected from downside risk.
Many investors believe bonds and bond funds are safe from downside risk. This belief is false! This mistaken belief is widely held because we are still in the middle of a historic 30-year bull market in the value of bonds that began in the early 1980s. (Or, conversely speaking, a 30-year bear market in long-term interest rates, since the value of bonds and interest rates move opposite each other.)
If and when interest rates begin a long-term rise again, you will see many unhappy bond investors, especially ones holding medium- and long-term bonds.
If You Are Retired . . .
And if you are in retirement, then bear market history tells us you should consider having 10 years of projected retirement withdrawals protected from downside risk.
A Solid Financial Plan Is Boring
I believe 24/7 news service has done a disservice to investors because it distracts investors from the financial planning fundamentals they should be focused on. The problem is that fundamentals are simple and boring, so they are not worthy of news coverage and would not fill up the airwaves long enough.
Just remember that 24/7 “news” media is ultimately in the business of entertainment, not protecting your retirement plan. So if the recent market volatility and the press coverage have you concerned, I suggest turning off the television, dusting off your financial plan, and reviewing its soundness.
Tim Van Pelt is a financial planner. You can reach him at [email protected] or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investing, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisors before engaging in any transaction.