From November 2007 through February 2009, the world stock market (represented by the MSCI All County World Index, net) lost 55% of its value. Every investor and financial advisor lost sleep during this period. However, the outcomes of investors varied widely, depending on their level of discipline and adherence to their long-term plan.
Some investors, spooked by the downturn and fearful for the future, bailed on their plan, swore off stocks, and put whatever money they had left into FDIC-insured bank accounts. Several years later, many of these same investors, after watching the market recover and then hit new highs while their cash earned almost nothing on the sidelines, plunged back into the stock market.
This extremely common investor behavior is a classic example of “buying high” and “selling low,” something we all know is a terrible investment strategy.
Mistiming the market, whether out of fear or speculation, is likely the most frequent and severe form of permanent capital loss investors experience. Even though most investors will eventually re-enter the market, they will have forever missed out on the outsized positive returns that typically follow bear markets.
Imagine a hypothetical investor who had $1 Million invested in the world stock market at the beginning of November 2007, but who sold near the bottom of the last financial crisis at the end of February 2009. At that point, his once $1 Million investment would be worth only $450,770. Five years later (end of February 2014), feeling confident that the markets have recovered and watching other people get rich while his money is earning nothing on the sidelines, he decides to reinvest his $450,770 back into the world stock market. At the end of 2015, his investment would be worth only $455,521.
Let’s imagine another hypothetical investor who also had $1 Million invested in the world stock market at the beginning of November 2007. Her investment would have also declined to $450,770 by the end of February 2009, but unlike the first investor, she had the fortitude to stay the course and remain invested even though it was very uncomfortable. At the end of 2015, her investment would be worth $1,113,640.
While the bear market in stocks was temporary, the first investor experienced a permanent loss of over $650,000 compared to the disciplined investor who stayed the course. Both investors experienced risk and both investors saw their investment fall by 55%, but only the investor who mistimed the market experienced a permanent capital loss.
The lesson here is not that every investor should be 100% invested in stocks, in fact, that is surely not the case. Instead, the lesson is that investors who need cash in the near-term or who have a very low tolerance for volatility should not invest in a stock-heavy portfolio in the first place. Conversely, an investor who doesn't need cash in the near-term should build a balanced portfolio, containing both global stocks and high-quality bonds, and then ignore market gyrations, stay the course, and not allow what are most likely temporary losses to become permanent losses.
Although it’s always possible that the global market won’t ever recover after a downturn, such a case resembles an Armageddon scenario where most assets (stocks or otherwise) might be worthless. Remember, stocks represent ownership in companies and as long as those companies have a future, the owners have a right to those future profits. As a result, I believe it’s best to be an optimist in this case, diversify your portfolio across the entire global market, and have faith that capitalism will continue to work in the long run. Although I believe it will all work out, I also believe it’ll be a bumpy ride so it’s important to maintain sufficient liquidity in “safe” assets for short and intermediate term needs and to build flexibility into your financial plan so that you’re still around for the long term. If you cannot get comfortable with this outlook and have faith in the long-term prospects of the global market, then you should seriously consider whether you have any business investing in stocks in the first place.
I often think of the temporal risk of stock market volatility as being akin to turbulence on an airplane. Some passengers find it uncomfortable, some will close their eyes and breathe deeply in order to stay calm, and some find it so terrifying they assume a plane crash is imminent and would prefer to jump out of the plane before it gets worse. On the other hand, the pilots and well-educated frequent fliers know that turbulence is just a normal part of flying through the air at 500 miles per hour and does not indicate that the plane is going to crash. For those who nevertheless find it too unnerving, the alternative option is ground transportation. While you won’t experience any turbulence, you’re far more likely to get in an accident and unless your destination is nearby, the journey will take 10 times longer, assuming your time horizon is even long enough to make it there at all.