One reason to avoid the stock market is because it could crash overnight. Scary thought, no? In a similar way to plane crashes, market crashes are vivid events that scare us more than they should, statistically speaking. Just as the drive to the airport is riskier than the flight. Below is an illustration of just how safe flying is compared to car travel. For the same amount of distance travelled, being in a car is actually much riskier than being in a plane. Fear and risk are different things.
Deaths Per 100 Million Miles Traveled – Car vs. Plane
In a similar manner staying in cash, rather than being in stocks, can prove more costly to the growth of your savings than investing. Once again, that part of the human brain which was just perfect for helping us avoid getting eaten by a tiger, entices us to be scared into making poor financial decisions. We worry excessively about the big and scary… but unlikely events, and end up overlooking the more mundane realities.
Below is a chart showing you for the S&P 500 going back almost 150 years how long it would have taken you to get back to the same level after the various market declines.
For example, to take the biggest ‘triangle’, if you’d bought stocks in September 1929 on the eve of the Great Depression when the S&P 500 was at 31, then you’d be waiting practically 25 years for the market to return to its prior level, which it ultimately did in September 1954.
Now, getting a little more sophisticated for the purists, we can adjust the data to include dividends and look at the real level of the index to take account of inflation (below). However, making these adjustments doesn’t alter the fundamental picture. With the exception of the Great Depression in the 1930s you’re looking at 15 years to make your money back if you happen to invest 100% of your money in US stocks at 4 of the worst months to invest out of the last 1,716 (a 0.2% chance). Even altering the date you invest by a few months in these examples, can improve the time it takes to break even by a fews years, so you really do need exceptionally bad timing to experience the worst results.
But let’s not rely on luck even though the odds are in our favor on this one. What are a few strategies we can use to minimize the risk still further?
Keep Stock Market Investing For Longer Term Money
So how should we act on this? The first thing to take note of is that stock market investing is not for short-term investors. You want to have 5 years at a minimum until you need money that you’re putting to the work in the markets, and preferably longer. Otherwise, even a small disruption (such as the large number of smaller ‘triangles’ on the above chart) could force you to sell at precisely the time when you would want to be invested. This means if you’re young and saving for retirement, then a high allocation to stocks appears justified. However, if you’re saving to purchase a house in 18 months time, then stocks are likely to be too risky to meet your needs.
To put this another way, on any single day the chance of the market falling or rising is little different than 50/50 with a 53% chance of a price increase. If you push your investment horizon out to a year then the chance of the market rising is 73% and on a 10 year view it’s 93%. The longer your time horizon the more confidence you can have that stocks will work out for you if history is any guide.
Making Saving An Ongoing Activity
The examples above show the risk of putting 100% of your money in one asset class at a single point in time and then failing to save any more. Ideally, you should save a proportion of your income every month. That’s good financial practice in its own right, but also means that your investment returns are likely to be smoother as you’re slowly building a investments position over time by stchaneady saving. If you’re saving steadily over time then you’re more likely to achieve closer to the historical 7% long-term returns of the stock market rather than experiencing some of the more acute highs and lows.
Pay Attention To Extremes Of Long-Term Valuation Signals
The Shiller Cyclically Adjusted PE Ratio (CAPE) can also be useful in this context. It’s fairly complex, based on looking at stock prices relative to their earnings over the past decade, but the underlying message is clear. Avoid being too heavily invested in stocks when valuations seem abnormally rich. This was particularly helpful in two instances in 1929 when the indicator was at 32x and in 1999 when it was at 43x. It’s long term average is 19x, and it’s currently at 27x. It seems that as the CAPE metric rises, long-term returns over the next 30 years decline, and research supports this view.
Don’t Consider Stocks In Isolation
There is also no need to be 100% invested in US stocks. Internationally diversifying your stock exposure can be helpful because the US is less than a quarter of the global economy on most measures. Adding other developed markets can help spread risk, and adding emerging markets given demographic trends may help long-term returns. This is especially so in the current environment when the US market appears relatively expensive by international standards, and so looking overseas may help you find a better risk/return trade-off.
To find further balance it’s important is to consider adding some bonds and Treasury Inflation Protected Securities (TIPS) to your portfolio, these can do well at precisely the times stocks do poorly so having at least 20% of your portfolio in these traditionally more stable instruments, and growing their share as retirement approaches can help smooth out your returns when you need it most. There are other techniques to add portfolio balance too; Real Estate Investment Trusts (REITs) can help in certain market environments and, we believe, tilts to value and smaller stocks can also boost returns based on on Nobel Prize winning research.
An example model portfolio to create balance we use at FutureAdvisor is below, though your exact allocation should be adjusted to your age, retirement goals and risk tolerance. The keys are to make sure you have a clear bond and equity split within your portfolio and diversify internationally.
See The Bigger Picture
Finally, remember that buying the S&P 500 (or any other investment) is not costless. Studies have shown that high fees such as those with more expensive mutual funds can eat as much as 20% of your returns over time. This is true even when these expensive funds are doing little more than tracking the index. If you have the right plan, but pay too much fees, that can easily cancel out much of your efforts. Also remember that dividends can boost returns beyond what you see on index charts, which typically exclude their contributions. Earning and reinvesting dividends can add up over the longer term.