Economic recoveries and bull markets move slowly; recessions and downturns move fast. So, be prepared...
Do you think that once a recession looms on the horizon, you'll be able to make preparatory moves to sustain your financial investments and your portfolio? If so, you're probably wrong. You're taking on too much risk and not effectively managing the risk within your portfolio and your financial life if you naively think that pre-recession prep isn't necessary.
Recessions come too quickly for most people - it'll probably be the same for you
Too often, people fail to take prudent steps to prep for recessions, market corrections, or economic downturns - they think they'll see the signs close to it and will be able to make the needed financial adjustments. This is incredibly hard to do, however, and most people fail at it.
The main reason it's hard to do is that, unlike economic recoveries and expansions, recessions come quickly and don't tend to give warning signs until after things are already bad (so, they're not really warning signs in this case).
There's too much prep work to do pre-recession
There is too much to be done to prep for a recession, and there might not be enough time to do it if you wait for some sort of warning sign to begin. These things may include the following:
The above items are essential if you want to both protect your financial and non-financial worlds during a recession. It's also important if you're going to thrive post-recession because of recessions, market corrections, and economic downturns bring asset prices down. The smartest investors are those who are eagerly awaiting a recession with a list of quality firms and other assets to buy up at low prices.
It's hard to find great firms at any time
Generally, quality firms are those who have healthy balance sheets, strong and growing earnings, proper management, and are engaged in businesses that are not readily open to competitive entrants. This is an entire field of study, however, and there isn't enough room in a single article to even begin to delve into this topic.
Sometimes luck gets in the way of us achieving our financial goals. Other times, we get in our own way. Don't make these classic financial mistakes - they have significant long-term consequences to your financial life.
1. Buy into the financial markets during market euphoria and sell out during the middle of an economic downturn: Far too often, people buy high and sell low instead of the often-stated "buy low, sell high" mantra. This has a lot to do with behavioral psychology and cognitive biases. A surefire way to take substantial steps backward in your financial life is to buy stocks (or any other asset) during a boom only to sell during a recession - this will result in capital losses, which are devastating to your financial portfolio.
2. Keep no cash cushion for the unexpected: Without a cash cushion (often called an emergency or rainy day fund), you'll need to sell less-liquid assets during harsh times for you and your family. Harsh times almost always do come, so neglecting to have a proper emergency fund in place will likely mean you'll end up selling assets at non-ideal times. Non-ideal is a good scenario. In fact, you could end up having to sell during a market correction or a full-blow recession (where asset prices can quickly drop by 50%). You can't afford to sustain such capital losses - having a cushion of money set aside as an emergency fund will protect you from this.
3. Fail to invest your savings: The first step to building wealth is saving - if you can't put money aside, you're going to have a hard time building real wealth in a sustainable and lasting way. Some people can save well, but they are afraid of investing. These people are often diligent and reasonably hard-working adults who don't like to take perceived risks. What they don't realize, however, is that for the most part, saving alone is not enough - you must invest your money at reasonable rates of return so that it may grow. Without growth, your wealth will only depend on your ability to earn income, and every year your wealth will slowly be eaten away by inflation.
How to use historical stock market data to build your investing intuition, and move one step closer to becoming an investing superhero
On Monday, October 17, 1987, the S&P 500 dropped a little over 20%. Going back to 1950, this was the single worst one-day drop in the stock market. It showed and taught a lot then, and it can still teach market participants and investors today if they are willing to listen.
Historical financial data can be magical - it can help you travel into the past and see the forests from the trees. By listening to historical data, we can more easily understand that a single-day drop of 20% in an index such as the S&P 500 is possible. By knowing that a 20% stock market drop is possible -- and by seeing the number present itself to us in the data -- we can better understand the risks we face by investing and participating in the financial world.
How do we know whats or of stock market drops are possible?
What exactly does possible mean in the context of investing and considering severe market declines? Sure, we know it's "possible" for the S&P 500 to drop by this amount or that amount. But until you ground your understanding in some historical data, you're not going understand this possibility at a deep level.
Observing the S&P 500's daily price movements will help you learn what sort of severe drops are possible for your portfolio
First, a quick note on using the S&P 500: The S&P 500 is a great place to start because it's a reasonable proxy for the market. The S&P 500 surely doesn't represent the entire market of equities, financial assets, and let alone of all assets; but, it's a reasonable and easily-manipulatable proxy for "the market."
If we care about how bad things can get in a single day (eg. an extremely severe yet plausible one day decline in your portfolio), we'll want to look at daily price data. This type of data is readily available online. There's a lot of free data, but you'll have to pay to access longer time horizons or more esoteric data.
Below, we have S&P 500 data April 3, 1950 to September 6, 2019. This represents an almost 70-year time horizon, a bit less than the expected lifespan of a person today. You can see this in the screenshots below (bottom and top of the table shown; table ordered earliest to latest).
The data has three columns - one shows the date, the other the closing price of the S&P 500 on that date, and the last column is the day-over-day change int he S&P 500 stated as a percent. The day-over-day change is easy to calculate - it's merely the one day change divided by the previous day's closing price. Declared as a formula, it is: [Day 2 - Day 1]/Day 1
This is called the arithmetic return. More complex return types -- namely the geometric return -- exist, but they are outside the scope of this discussion. The simple arithmetic return above is sufficient for our purposes.
Observing financial market data can teach you a lot and help to build a bit of market-related intuition
Just observing stock market data like this can be useful. Exploring data visually without graphing it can give us some interesting and potentially-valuable preliminary insights. This is especially true for people who haven't done this sort of data analysis before. For example, we can observe that in the very beginning of our data set (the first few days of April 1950), the S&P 500 was around $18. This is in sharp contrast to the almost $3000 S&P 500 level we observe below for September 2019. This plainly shows us that there has been some dramatic growth over the last 70 years in absolute metrics.
Although we can see some things by observing the financial data, it's hard to determine summary statistics about the S&P 500 data set visually. Stats like mean, median, minimum, and maximum are hard to see because all of the data needs to be taken into account. Taking all of the data into account can't easily be done relying on the human mind - it's just not what it's made to do. The data set has almost 17,500 rows - that's simply too much to comprehend without the use of computing devices/methods (or without a considerable amount of time to devote to this endeavor). Luckily, such devices/methods are easily available for free (eg. Google Sheets) or cheap (eg. Microsoft Excel) in the form of software. More complex options are available that are both free and paid (eg. R, Matlab, Tableau, etc.). Something like Microsoft Excel would be enough for the vast majority of use cases, however.
Finding the minimum, or the worst stock market day over the last 70 years
Some relatively easy functions can be used in Excel -- the tool of choice for most finance people -- to get some stats on the data. In the screenshot below, you can see the average, the max, and the min. The min is what we care about most here - it represents the lowest day-over-day S&P 500 change; it represents the most severe single-day drop in the S&P 500 over the last 70 years.
We can see that the worst drop is -20.47%. That means that in one single day, the stock market effectively dropped by over 20%.
Black Monday - an over 20% one day drop in the stock market
We can see the drop occurred on Monday, October 19, 1987, by examing our data set in greater detail. By filtering the data from largest to smallest, we can see what date corresponds to the worst stock market drop. Once we have the date, we can observe what happened around it in the days before and after Black Monday, which is what Monday, October 19, 1987is called in the financial industry.
The image below is the copied and pasted data from around Black Monday. It's interesting and useful to observe what happened around that time. We can see in the 10 days around Black Monday, 7 out of 10 days were losing days. We can also combine the losses to see what the cumulative loss over the 10-day period would have been. We can see that it's even worse - over the 10 days, the stock market dropped over 26%.
That means you could wake up one day over the course of your investing life and see that your portfolio is down 20% in a single day. That event would be tough to deal with - you'd be in for a very rough day and rough week. It would take some time to recover from the loss, but recovery would definitely be possible. A mistake, however, would be to panic and deviate form your long term investment strategy for no real reason beyond the fact that you're freaked out.
Use this knowledge to avoid panic sales and other forms of freaking out during the next inevitable stock market disaster
We all get freaked out in investing - it's your money that's on the line, and you don't want to lose it. Even small drops can seem bad. Even times where there's no movement could be perceived as bad if you were anticipating gains. You can't let these investing difficulties make you make investing mistakes, however. You've got to do your best to maintain a long-term perspective on investing. Something that helps us do that is exercises like the one we just went through. Looking at historical market data, understanding how the markets have moved over time, and understanding how markets may tend to move int he future are all essential things that will buffer you from foolish investing mistakes made out of fear.
If you'd like to explore the Excel file form which the above screenshots originated, you can download the file here. You'll be able to copy and paste the S&P 500 data to do your own data analysis work, like finding the maximum one-day increase.
At the beginning of your wealth-building lifetime, it's your rate of saving and investing that matters more than your rate of return
People in the investing and financial world fetishize rates of return. Often cited and mentioned in financial articles is financial/investing genius Warren Buffet. Since 1965, Buffet has generated (thru 2017) approximately 21% annually. This is astonishing and deserves both praise and diligent study, but for most people who are in the early stages of their investing lifespan, it isn't relevant or useful.
The reason it's not relevant or useful for most people who are in the earlier stages of their investing timeline is that a focus on investing rates of return is useless and distracting. It's not the rate of return that matters most for a twenty-something or thirty-something investor. Instead, it's their rate of saving and investing that matters far more.
Barring ridiculously large and deeply improbably investing returns, getting more return won't be as beneficial as saving more. Imagine you have $1000 today, you can get an astonishingly high 50% return, or you can save another $1000 and get a100% gain effectively. If you've got $10,000, this becomes harder to do unless your income is very high. At $100,000, it's very hard to save an additional $100,000 - you'd likely want to start giving proper focus to investing returns. At $1 million, you'd likely begin to see more gains from investing than from saving. Obviously, these numbers need to be adjusted depending on income, but the core principle remains the same - if you don't have a lot of capital to work with, stashing away more capital is going to be better for you than trying to finesse something with the small amount of capital you do have.
With each economic cycle in modern economies, we experience the same thing - there's a boom, then a bust, then a recovery, and then another boom...
It's typical after a long period of growth for investors, the financial media, and your everyday Joe Shmo to start thinking that a recession looms on the horizon. But, recessions don't like fear - people freaking out doesn't usually beckon a recession.
In actuality, recessions are more often seen right after periods of intense euphoria in the economic and financial worlds. These times are marked by excessive optimism and a fear of missing out (FOMO) by many market participants. During such times you'll hear people traditionally not involved in finance or investing talking about investing - this is markedly different than how people act during times of fear or caution.
Thinking that a recession is near when most others think this is an error in most cases - one likely based on not understanding financial market history well enough. Although real panics will very likely have macroeconomic consequences (and might cause a recession or even a depression), general but relatively subdued caution and fear is not likely going to be the cause of a recession. It's when people expect it the least do macroeconomic downturns start to brew.
From a mathematical perspective, those in Finance can clearly show you how not being diversified -- in an economy that allows for diversification -- is not prudent. Why isn't it prudent? Because, for most investors, not having all of their eggs in one basket will prevent them from devastating loss should some baskets break. Baskets break all the time.
Although diversification is an ancient concept, the modern idea of financial diversification in the context of creating an effective investment portfolio can be attributed to Harry Markowitz. Markowitz published his seminal paper titled Portfolio Selection in 1952. Check it out here, and other places online.
Some investors, however, feel that they don't need this rule. Some investors think the rule, or more precisely, the nature of the world in the investing space, doesn't apply to them. They feel that they know more than the typical investor or investing firm knows - they think they're somehow better at picking stocks or making investment decisions. These people -- and they are everywhere -- believe that they're just different. It's a common thing in humanity, and it might not change.
In the context of investing -- and specifically retail or family office investing -- portfolio concentration risk is the risk that you are overly exposed to something. That something can be any of the following and more:
Inappropriate portfolio concentrations are those that expose your portfolio to more risk than you would like or more risk than would be prudent. As such, assessing the concentration levels within your investment portfolio and taking steps to ensure that they are in line with your goals is a smart thing that should be done every so often.
The good thing is that it’s pretty easy and straightforward to determine the concentration levels for a lot of things like stocks, sectors, and countries (things like determining the concentration to strategies and assumptions is a bit more complex).
Step 1: Compile your entire investment portfolio
This might be the most difficult part as modern investors often have portfolios spread out amongst different account or different institutions. For example, you might have a brokerage account, a savings account for an emergency fund, some random savings accounts, and a 401k plan at work – this isn’t unreasonably complex but it does mean you’ll need to do a bit of work compiling things initially.
In fact – you should have done this already; the info should already be complied! If you’re investing and you don’t have a single source that is updated at least occasionally where you can get a high-level picture of your portfolio, you’re making a mistake. Spending some time on this will be beneficial in many ways, beyond just understanding concentrations and concentration risk.
Step 2: Pick a concentration category (eg. stocks, countries, sectors, etc.)
Next, pick a category against which you'd like to determine concentration levels in your portfolio. Don't start with complex things - start with basic things and move towards more complexity as you slowly get a better understanding of the risk nature of your portfolio.
For example, a great place to start would be sectors - you don't want to be exposed to a particular sector too much. If you're only in tech stocks or only in blue chips, you might want to diversify at bit more, depending on your risk tolerance and investing horizon. At the very least you'll want to know that you're heavily concentrated in particular sectors.
Other key concentrations are for individual stocks (eg. the investor who's absurdly exposed to one particular stock they love at the detriment to proper portfolio risk management and diversification).
Step 3: Simply make a list
For a retail investor doing simple portfolio concentration risk analysis, once you have your portfolio in one place and once you decide what you want to examine, it's very simple to proceed.
All you need to do is make a list with two columns - the particular investment product in the right column and the percent of the portfolio that the investment product represents. This is best illustrated by the table below.
As you can clearly see, this isn't a healthy portfolio. The vast majority of the portfolio is concentrated on
The portfolio has home country bias and seems to biased toward popular or newsworthy tech stocks and friend/family tips. Only 30% (broad market ETF + global ETF) of the portfolio is in a broad, well-diversified, investment product while 55% of the portfolio is in just 3 stocks. That's simply absurd for most investors - unless you're an excellent/skilled investor with a very long time horizon and a high risk tolerance, that sort of exposure is unacceptable.
Step 4: Take prudent risk-mitigating steps to reduce the concentration risk within your portfolio
Finally, after the analysis, you would take action - you'd act in ways to adjust your portfolio to reduce concentration risk. Of course, in doing this you'd want to be prudently confident in the insights on which you base your decisions and you'll want to take other factors into account - these other factors might include tax implications and macroeconomic assumptions.
In our example above, a prudent investor would sell off some of the tech stock exposure and re-assess weather the family member's energy stock tip was actually a good tip (eg. is the stock worth owning). Then, the investor might take the proceeds from these sales and invest them into more well-diversified products like ETFs, focusing both on foreign and domestic ETFs. The investor would also want to make sure to focus on both small cap and large cap ETFs, keeping in mind their risk tolerance and adjusting appropriately.
Finally, the investor might see that they are only in equities - this might make sense but putting some money in bonds or alternatives might make sense for some investors. These decisions are all individual - one needs to act prudently based on their own circumstances.
Concentration risk is only one type of investment portfolio risk, but it's an easy one to spot and fix. A lot of investors are prone to taking on too much concentration risk. They don't do it intentionally - they just lack an investing plan or approach and instead buy stocks here and there based on emotions. This is hard to remedy - not everyone is going to create an investing approach and monitor it over time. But, people easily -- and enjoyably -- do the above exercise once in a while (at least once a year) to see if their portfolio is too concentrated on one stock, one sector, or one economy.
Devastating portfolio declines and what it takes to recover from them – the math isn’t in your favor
Everyone thinks about gaining money when they invest, but too often we neglect how important it is to not lose money. Not losing money is so important, in fact, that one of the greatest financial investors in history (and very likely the greatest one alive today) espouses the following as his Rule No 1:
Don’t lose money.
What’s Rule No 2?
Remember Rule No 1.
Rule No 2 is obviously meant to be a little humorous, but Buffet is a serious man when it comes to investing and his rules are meant to illustrate a fundamental truth about investing – that truth is that it’s very hard to recover from a loss and that it gets harder and harder the deeper the loss.
This is all best illustrated with examples. Sometimes, a good set of examples can do more for contributing to understanding than pages and pages of text. So, let’s go over three examples, each with increasing levels of severity of initial losses.
In each example, we’ll break things down into 3 time periods – Time 0, Time 1, and Time 2:
A 25% Loss – Somewhat severe, but recoverable
With a 25%loss, your $1000 declines to $750 – this represents a one-quarter decline in your portfolio and would obviously be an unwelcome occurrence. Now, let’s take a look at what sort of returns you’ll need to recover by Time 2; let’s see what sort of returns in the subsequent time period you’ll need to make you whole again.
As you can see from the table, a 33.33% gain is required in order for you to recover and get back to the initial $1000. A 10% return, 20% return, or even a strong 30%return in one time period simply won’t do it.
That means if each time period is 1 year, even a 30% return in the year subsequent to your 25% loss won’t be enough. 30% is a solid return. The fact that it’s not enough should be the first hint that getting back to whole is a lot harder than dropping, from a mathematical/percentage perspective. It’s only going to get worse.
A 50% Loss – Very severe, but you can recover if you stay prudent over the long term
With a 50% loss, it’s a lot harder to recover. Now, it takes a 100% gain (doubling your post-loss portfolio value) to get back to whole again. If you halve your portfolio, you’ll need to double it to bring it back to its original value.
So, if a time period is one year, you’ll need to double your post-loss portfolio value to get back to your Time 0 initial value. That’s very hard. You’d be far better off having avoided such a decline because it’ll be an uphill climb getting back to baseline again. This is what Warren Buffet’s Rule No 1 points to.
A drop of 50% in your portfolio value is very severe and detrimental to your long term investing goals. It will take a 100% increase -- doubling your portfolio -- to recover from a 50% loss. This is tough, but it's doable - it might not happen in a single time period but over time a prudent and disciplined investor stands a chance at recovery.
A 75% Loss – A devastating blow to a portfolio that will take some time to recover from
With a 75%, things get really bad. Now, in order to get back to whole, you’ll need a 300% gain. A 300% gain is the same as quadrupling your money (4x return). As any investor knows, a 300% return is very hard to get – it usually takes years to achieve such returns in a well-diversified portfolio.
Let’s think about this some more. As we keep increasing out Time 1 losses by 25% increments, the return needed to get back to whole by Time 2 goes up by way more than 25%. This is based on the underlying mathematics of portfolio returns, but we don’t need to get deep into that here. The above examples should clearly show how each time the loss gets more severe, the needed gain to get back to baseline gets more and more astounding.
If you lose 75% of your portfolio’s value in a single year due to a very severe recession or, far worse, due to investing blunders, you’re going to have to make some incredible returns (300%) to recover. What makes you think you’ll beable to do that? It’ll likely take a number of years and some serious investing discipline to be able to recover in this way.
A 75% portfolio decline is devastating to any portfolio. It will take a 300% return (quadrupling your money; a 4x return) to get back to whole again. This is very hard to do in a single time period. It might take years of prudent and disciplined long term investing to recover. This demonstrates why large portfolio declines are so detrimental and should be avoided.
A bit more mathematical, for the mathematically inclined
For those that are more mathematically inclined, let’s dig a bit deeper into the portfolio maths.
Let’s assume an initial portfolio value of a – this is your Time 0 value
For any portfolio change (decline or increase) d, where is greater than -1 but less than 1, the portfolio value in the immediately subsequent period (Time 1) will be a x (1 + d)
To get back to the initial portfolio value by Time 2, we’ll need to do something to the Time 1 value to get it back to a (which we stated above was our initial value)
We can simply divide the Time 1 value by (1 + d) to get back to a – that’s [a x (1 + d)]/(1 + d)
Dividing by (1 + d) is the same as multiplying by 1/(1 + d) – that’s the amount, no matter what our initial a is and what the change d ends up being, that we have to multiply the Time 1 portfolio value by
Now, notice that if d is less than 0, 1/(1 + d) will be larger than 1. So, if d is -0.25 (corresponding to a 25% decline in our first example above), then 1/(1 + d) is 1/(1 – 0.25) which is 1/0.75. What’s 1/0.75? It’s 1.3333. That means you’ll need 1.3333 times the Time 1 value – this exactly represents an aprox 33% increase.
Let’s do a 75% decline as in the third example above – now 1/(1 + d) is 1/0.25. That’s equal to 4, which represents a 300% increase over the Time 1 value.
We can see that as d approaches -1 (moving towards a total loss), 1/(1 + d) gets bigger, but by a disproportionate amount.
Can we derive a simple way to see how our 1/(1 + d) factor changes with changes in d? Yes – it’s easy using Calculus:
d/dx[1/(1 + d)] = d/dx[(1 + d)^-1] = [-(1 + d)^-2] x d/dx(1 + d) = [-(1 + d)^-2] x (0 + 1)
so, the derivative is -1/(1 + d)^2
Calculus can be applied to lots of situations to better understand how things change. F
We can see that by squaring the (1 + d) term, we’re increasing the effects of both positive and negative portfolio changes. If d < 0, then squaring (1 + d), which will be less than 1, will only make the factor smaller. By making that factor smaller, the entire factor gets bigger because dividing 1 by smaller and smaller numbers makes the result bigger and bigger.
This should be very discouraging – the numbers tell us that negative effects are magnified when we think about the returns needed to recover.
One of the best ways to calm your anxieties during market turmoil is to track your portfolio over time in a robust and sustainable way. What does that look like? It means periodically and consistently -- on a weekly or monthly basis (daily is too volatile and yearly is too high level to see intra-year fluctuations) – in a way that makes you actually have to engage with your portfolio.
This means using software or an app to track might not be sufficient if the app does all of the work for you. One of the best ways to do it is to use an Excel file and simply list your total portfolio value over time, row by row, with each row representing a particular point in time (see example below).
What this will give you is something incredible – it’ll give you some perspective. Perspective is an amazing gift, but it isn’t very easy to come by. To get real perspective, there aren’t a lot of shortcuts you can take – it takes time. But, even if you have been investing for years and years, you still likely won’t gain perspective if you don’t track your portfolio but instead mindlessly go about checking it every once in a while without putting its current value in appropriate historical context. Remember - perspective is earned.
By having some perspective, you'll be less likely to make dumb investing mistakes. When stocks go down severely due to short term market turmoil, you'll have enough historical perspective to understand that markets are volatile in the short term.
This is useful for all sorts of investors - those that invest in stocks obviously, but it's also useful for investors in real estate, derivatives, cryptoassets, and even fixed income (although fixed income can be a bit more complex because it is exposed to interest rate risk in addition to market risk).
Expand Your Understanding of the Investment Possibilities that Exist
Most people in the western world have an overly narrow view when it comes to investing - they usually think one of those places for storing money:
Even the above list is broad - most young people today don't readily buy bonds or invest in bond funds (even though the overall bond market is bigger than the equities market). Unless you're lucky enough to have had your grandma buy you a bond, you've probably never owned one and you might not even really know how one works.
So, that leaves us with equities or cash - is there nothing else? Of course, there is something else -- most people have been doing other things with capital rather than buying equities or saving cash -- throughout history. You just have to open your eyes to the broader investing and capital allocation universe that's out here.
Of course, you shouldn't be foolish - equities (eg. stocks, mutual fund, and ETFs) and cash are better understood and offer a lot of advantages. But a person can also invest in:
getting even deeper and more complex, you can invest in things aren't aren't even assets but things that might bring a return later on. These might include:
Again, no one here is saying that you should forget the bread and butter that cash and equities offer the broad swath of the investing public - far and away these should (for most people and in most situations) make up the majority of your saving and wealth-boiling plan. However,r it's smart to lift your head up once in a while to see other possibilities and opportunities available if only to build a better and more comprehensive understanding of what capital allocation, investing, growth, return, and success really mean in your overall financial life.
The Importance of Failing at Investing - It's Almost a Prerequisite to a Successful Long-term Investing Track Record
Failure is always unpleasant but a part of life that can teach. Not all things require failure - you can be a great academic and never fail a class and you obviously don't' want to be an engineer or an architect that ever fails. However, with investing, it's a whole different game - failure early on is almost a prerequisite to a successful long-term investing track record. It's not only that failure is ok, it's almost that utter failure early on (or possibly later on, but early on is better because you usually will have less invested early on).
Financial Markets are too Difficult to Predict
This is a pretty bold statement we're making - we're saying that not only is failure ok but that failure in investing is almost a prerequisite for a good long-term investing track record. This is the case because investing -- unlike so many other professions and activities -- involves intense levels of uncertaintly and potentially chaos. The markets are uncertain and can act in chaotic ways. Additionally, when they are chaotic, they are of the more complicated second order chaos variety - this means that not only is it hard to predict financial markets but that in attempting to predict them we influence them as well. The problem is that humans have a lot of deep-seated heuristics and cognitive biases that intensely cloud our thinking and prevent us from acting in rational ways.
Cognitive Biases and Heuristics Can Lead an Investor Astray
An engineer or an actor or an architect or a college student or an academic doesn't need to fail because their professions are (1) far less uncertain in terms of predicting outcomes and (2) rely on things that are less affected by heuristics and cognitive biases. For example, a bridge builder uses principles of physics to predict the behavior of materials in various situations - not only does this prediction not involve deeply complex or chaotic systems, but it can also be tested in small-scale environments before being implemented (something that's not really possible in a world where time travel hasn't been invented yet). Here's a brief list of some heuristics and cognitive biases:
Two Main Benefits of Investment Failure
Failure in investing does one of two things (and maybe both):
A Real-Life Example of Investment Failure
As an example, I failed big time when I was about 20 years old. This was right before the Great Recession and my friend was working at Washington Mutual as a teller while going to school - the now defunct predominantly- Western bank that was purchased by Chase after it's collapse. We were young college students interested in entering the market and we had no inkling that the Great Recession might come. We bought a significant amount of WaMu stock. Then the economy tanked and the stock went down. We were pretty heavily invested in this one stock at the time. He went to his job every day and he told me no to worry - after all, how could a big bank like this with so much real estate and so much branding and so many customers collapse? It wasn't going to happen. Then, the bank failed and we lost our entire investment.
That experience taught me a lot about investing:
There have been 22 recessions since the turn of the 20th century -- see the table below for a list of all of them (sourced from here) -- and we have currently experienced one of the longest expansion in US history as of early 2017 - by June 2017 we will have experienced an 8-year expansion (almost 96 months) - this is the third longest bull market in over 100 years. Clearly at some point within the next 2 to 5 years, we're going to experience a recession.
This article isn't about 2017 or this latest bull market, however - it's about the economy in general and the fact that things so far have been cyclical. Given the last century of markets, we can safely assume things will continue more or less the same way unless deep structural changes cause some sort of change. These types of changes might be:
Until those things happen, a prudent person would assume a recession will occur when a bull market has been going on for a long time.
Can you predict when a recession will happen? NO.
Can you predict how bad the recession will be? NO.
BUT, can you reasonably assume there will be one? YES.
Now, why are we writing this piece? Doesn't it seem obvious? Well, in fact, there are generally two schools of thought in personal finance and investing when it comes to recessions - neither of which are healthy for most people to adopt:
What's a better option? The better way is to simply observe things in light of historical data and without trying to quantify things. In this observation, you need to be incredibly humble of your lack of ability to really predict much but you still need to be mindful of the length of bull market runs. As the run gets longer - as Year 1 turns into Year 5 and then turns into Year 8 of a bull market you will want to
Most people will sell during a recession - usually after having purchased at the previous highs in a euphoric frenzy. You, however, should be sitting calmly with a pile of cash ready to buy excellent stocks at very low prices. In the meantime, you'll still want to be investing - you don't want to stop investing and wait for a recession because you can't rally predict when it will come and you don't want to spend years sitting around waiting without getting any market returns.
Be wary of those individuals who try to predict things too much, in fact, add a lot of risk to the equality. The risk comes from the false assurance they provide themselves or others - it is better to wisely understand your total lack of knowledge about something than to confidently go forward when ou really don't understand something. As Mark Twain so eloquently stated: "It ain't what you don't know that kills you, it's what you know for sure that just ain't so."
You can't predict when a recession will hit, but you can be sure that a recession will come at some point. Speculation on the exact timing is a fool's proposition, but indicators exist to indicate when the overall market is overvalued and when a recession is more likely. Preparation for a recession is wise and simply ignoring overall market valuations will cause you to (1) not be ready to take advantage of investing opportunities a recession presents and (2) be potentially exposed in troubling ways due to improper diversification. The below 3 strategies are excellent ways to prepare for a recession.
1. Start Piling Away Cash for Cheap Stock Purchases When the Recession Hits
Cash is dry powder to investors and without some set aside you simply won't be able to take advantage of a recession. Cash will allow you to buy good stocks at deep discounts when the market falls during a recession.
Do you notice how the first thing we're advocating in terms of recession preparation is something that will allow you to buy more stocks instead of something that is meant to protect you? Obviously, you want to be protected in severely adverse market circumstances as an investor, but the most important thing about a recession isn't what it does to your portfolio in the short term, but the potential it has to boost your portfolio in the long term. A recession allows you to buy a lot of good quality companies at deep discounts - sometimes you see a price to earnings (P/E) ratios of indices such as the S&P 500 can drop below 10, indicating an extremely undervalued market overall.
Without having cash piled up ready to toss into good companies -- it's key that you only buy good companies -- you will miss out on potentially outsized gains due to inevitable market recoveries. The great thing about recessions is that you don't even have to pick individual stocks - something that is not recommended for novice investors or those with low-risk tolerances. Purchasing indexes (eg. S&P 500 or the Dow Jones) via broad mutual funds or ETFs will allow you to at once diversify and benefit from future recoveries. Purchasing the Dow Jones at the bottom of the 2007/2008 Great Recession would have created a 300% + return over the course of a decade without having to take on the risks of owning single stocks or having to put in the effort to pick them.
When the market seems overvalued in terms of market P/E ratios, in terms of timeframe since the last recession, or in terms of high-quality research/opinions, it might be a good idea to slightly pull back on some of the more speculative investing you're doing to put aside cash. You'll want enough cash so that you can comfortably enter positions at lows and then continue buying more and more if markets continue to drop. This abundance of cash will allow you not to think about timing the market -- something that you will not be able to do -- but will instead allow for an aggressive dollar cost averaging strategy once things start to decline until things start to turn up again.
2. Properly Diversify Your Portfolio so it Can Withstand a Recession
To make your portfolio more resilient to recession declines you'll want to diversify across:
You don't want to hold just US firm and you don't want to hold firms only in a single industry (eg. tech). Instead, you want to hold a broad portfolio of high-quality firms from around the world and from different industries. Some regions and industries will be more resilient than others and this will affect your portfolio. additionally, some firms will go bankrupt in recessions - hopefully, you don't own any such firms because you've done proper due diligence but some things are very hard to predict. You'll want to not be tied to a single industry, a single location, or a single firm when the market turns downward so that a single disastrous event will not affect more than a small portion of your portfolio and so that you can survive as an investor into the recovery.
A great way to diversify is through the use of mutual funds and ETFs, but diversification is also achievable through simply building your own high-quality stock for experienced investors - moderately experienced investors should not try this (novice investors shouldn't even think about this).
3. Buy Protective Puts on the Market (ONLY FOR ADVANCED INVESTORS)
If you don't know what a protective put is, this section is not for you at all and you should skip tot he end of the article.
If you do know what a protective put is but wouldn't be properly considered an advanced or experienced investor, you can read this section but you should not engage in this activity because it could cause a needless drain on your portfolio and a false sense of security.
If you're an advanced investor, you probably already know this strategy, but we'll remind you again. Protective puts are simply put options - they are called protective because of the context they are being used in. You can buy such protective puts on the overall market via market proxy (eg. S&P 500) in order to profit from market declines.
One way to execute such as strategy is to buy monthly out-of-the-money puts on the market proxy via a mutual fund or more likely an ETF. These should be out-of-the-money because what you're buying here is a form of insurance in case the market drops significantly - you're not trying to speculate. Out-of-the-money puts will be worthless if the market goes up or doesn't move much but will increase in value in a significant market decline. You can buy them for a reasonable term - monthly, quarterly, yearly but shorter repetitive purchases might be better because you're less exposed to the option's time decay.
If you're invested in the stock market -- be it with an individual portfolio, through an IRA, through a robot-advisor, or through a 401k -- you should know that markets will decline, economies will suffer, and your portfolio value will decrease. You can try to create a situation for yourself where you won't be exposed to the volatility of the markets, but the only real way to do this is to not be invested in equities at all - by entering the markets you're implicitly accepting a certain amount of short-term volatility that could cause you to see your portfolio drop by quite a bit. It's how you handle this drop that determines your resiliency as an investor and, in the long-run, that determines whether or not you're a successful investor.
Recessions Will Occur and Markets Will Decline
First, it's key that you understand that market will decline - you can't hide from this unless you're not invested in equities. If you only hold cash or fixed income securities (eg. bonds), you can safely ignore market prices on equities. In the case of cash, you don't care about the market either way. In the case of bonds -- although bonds can of course rise and fall in value based on credit worthiness and interest rates -you generally are more concerned with the ability of the borrower (eg. sovereign government, municipality, or firm) to pay as the agreed-upon schedule. If you hold stocks, however, you are exposed to two key factors:
Exiting the Stock Market at a Macroeconomic Downturn is One of the Greatest Mistakes an Investor Can Make
Imagine you own your house outright in 2007 and then in 2008 through 2010 the housing market starts to decline as it did in the US. Would you sell your paid-for house after seeing a drop in real estate prices of 30% or more? Clearly, that would be idiotic if you didn't need the money for something specific. Why, then, do so many investors feel so inclined to sell their stocks after a market drop? Just as with a paid-for house, you own your stocks outright unless you bought them on margin (highly unlikely for most retail investors).
Adding a mortgage on the house makes the situation riskier and it is, therefore, more understandable that you might need to sell your house in an economic downturn (eg. income loss). However, people are still far more inclined to sell losing stock positions in a macroeconomic downturn than they are to sell their mortgaged house. This doesn't make any rational sense and it represents a fundamental flaw in the way most people approach their portfolios.
Now, if something fundamental changes - meaning one of the following:
THEN you can be justified in existing a position. In this case, you'll be exiting, not because of a macroeconomic decline, but because of a macroeconomic change to your world of the stock you're holding.
In other circumstances, however, existing a previously good position is just foolish and will lead you to underperform the market over the long term. Additionally, you'll be effectively shooting yourself in the foot - you will be purposely selling off at the worst possible time instead of holding out a bit for a far better market scenario where a more fair value can be obtained for your investing.
Play Mind Games With Yourself to Prepare for the Inevitable Market Decline
One of the greatest ways to prepare for the inevitable market collapse (if you still think that this won't happen you need to go back and diligently study investing history before you proceed any further into the markets) is not use the same tactic elite athletes use to prepare themselves for competition - mental visualizations of game day with a focus on the desired outcome and the challenges that will likely be faced.
Elite athletes focus on the win, but they also visualize and understand the pain and the suffering that game day will likely entail. Instead of being optimistically naive, they in advance fully understand how difficult game day will be, they accept that difficulty fully, and they commit to persevering in spite of it.
Applying that same theory to your investing life you might want to visualise the goals you want to achieve (eg. the return you want to obtain over time or the number you want to hit in your portfolio) but you also will want to sit down and imagine how a 10% market drop will feel, how a 25% market drop will feel, and how a 50% market drop will feel.
Typically a 10% market decline will occur once every couple of years, a 25% market decline will occur once every decade or two, and a 50% market decline will occur up to a few times in your investing life. Failing to prepare for this almost inevitable circumstance could cause you to sell at a 50% market drop - clearly a very unpleasant outcome if waiting just a few years would allow you to recover all of your gains as has been shown via a study of US stock market history.
When you're playing these mind games with yourself it's key to really visualize the scenario and get that negative feeling in your gut you would get on the morning fo the crash. You will likely not have as intense emotions as you would actually staring at your dropped portfolio, but you should definitely feel that nasty feeling in your stomach. If no feeling accompanies this exercise you're doing it wrong and you should continue doing it over time until you really get that unpleasant gut feeling.
Once you have that gut feeling, let it wash over you and don't try to make it go away as humans tend to do with all emotions. Let the feelings stay with you and explore it a bit. See what that feeling is telling you to do. Realize how your emotions are ruling over you instead of anything rational - this is dangerous because investing is very unnatural to human beings and only rationality will help you do well. Tell yourself
It's important to not underestimate the power of such mental exercises. It's easy to dismiss this and argues that imagining things during a bull market won't help you when things really go bad and you actually are sitting in front of your broker's website looking at a number that is 50% less than it was yesterday. Of course, the two things aren't the same, but the power of visualizing is far greater than meets the eye at first. A lot of mental resilience to making foolish moves can be built up using the exercise above and be doing it once a quarter will over time create a healthy mental discipline against acting like a crazy person when things really go bad int he stock market.
The stock market has proven a great investment over the last century - investing prudently and in a disciplined way in the stock market would have yielded great results in every two-decade-long period in the US. This means that no matter where you start in the last 100 years (even a day before the collapse that started the Great Depression), if you invested wisely (meaning you diversified and dollar cost averaged into the market), you would have been far better off by investing in 20 years than you would have been holding the money in cash instead.
If this is the case, why are so many people so afraid of buying stock? Here are 3 reasons why:
1. You Don't Understand What a Stock Actually Represents
If you're afraid of investing in the stock market, you might simply not understand what a stock actually represents - you literally don't know what it is. Of course, you've heard of stocks and you know they are some sort of financial instrument or products, but if pressed you probably can't give even a basic definition that would clearly define what a stock is.
If you're in this camp of people, it does make a bit of sense that you're hesitant to invest in equities and delve into the stock market. People are often (and often rightly) afraid of what they don't understand - human nature keeps us safe by making us a bit frightened of the unknown. If you don't really know about something, how can you know if it's good or bad? Just as importantly, if you don't know about something, how can you know how to deal with it in productive and effective ways? Maybe it's better to just stay away from those things you don't know?
Staying away might be a good idea for some things in life, but it's a bad idea when it comes to delving into the equities market in your financial life - by not investing in companies around the world through the purchase of shares on the stock market, you are denying your financial self and your portfolio one of the best ways regular individuals can have a piece of the global financial pie and ride the wave of global growth over the long term. Without investing in stocks, you're not going to benefit when global GDP increases - you're going to have to rely either solely on your own labor income or a bit of interest income you'll earn by letting other people use your capital. Buying shares of good firms around the world, however, will allow you to literally have an ownership state in the global economy.
So, if you don't know anything about stocks today, it's time to learn. Fortunately, you're already ahead of many others because you're here reading this on this website - you've already taken a crucial first step. Next, you'll want to pursue around Pennies and Pounds a bit more in a free-form way to just get a feel of the kind of stock-related information that is out there. Once you've got a general conception, a book or two will prove quite useful in helping you delve deeper and learn more about personal finance and the stock market. Never underestimate the importance of learning about personal finance - your financial life is a key part of your overall life and not spending any time in studying up is as foolish as not going to school but expecting to do well in the job market.
2. You've Invested in the Stock Market in the Past, but You've Been Burned and Remain Scarred
Maybe you do know about stocks. Maybe you've even ventured out into the equities market in the past. And maybe you've been burned by it. Maybe you've
If the above happened to you, it's no surprise you're hesitant to go back into the stock market. You probably feel like
Although it's understandable that you feel this way, it's totally wrong - you're wrong if getting burned in the past has fundamentally created a negative outlook of the stock market for you. You got hurt in the past not because there are fundamental flaws in the stock market or that investing in stocks is simply not for you - you got burned because you made incorrect decisions.
Investing in stocks well requires a certain amount of basic knowledge. Things such as
If you got burned in the past in the stock market you probably bought a single stock or just a handful of stocks - this is foolish unless you're a Warren Buffet and for most people proper diversification is key. If you invested in Lehman Brothers or Pets.com or any other hot stock pic, you would have gotten burned - you invested without diversification and you invested in the wrong thing.
If you're going to stock pick, then make sure you pick the right stock. is not possible for most and, therefore, stock picking should be avoided like the plague. Instead, diversification via the use of mutual funds and exchange-traded funds (ETFs) should be utilized with a few stocks here and there if you're willing to take on the risk. Additionally, a robust (but not too robust) cash position (that is separate from your emergency fund) would provide liquidity and help reduce the overall volatility of your portfolio.
You also might have gotten burned because you invested at the wrong time (eg. the Dot Com Bubble or in 2006/7) and then sold at the wrong time instead of waiting for the market to recover. Instead, you should have:
Instead of going in at once, a dollar cost averaging approach where you invest a bit every month or every quarter allows for less risk because instead of investing at a single time, you can take advantage of market drops by having your money purchase more stocks, mutual funds, and ETFs. Additionally, you must be disciplined enough to not sell in a market panic - this is very hard and this is what kills most investors. You need to study the history of the stock market and keep that history in mind in order to temper the craziness that will arise in your mind when you see your portfolio going down. A good investor that is invested in a strong and diversified portfolio will not sell at a panic - this investor will understand how foolish it is to liquidate positions at a market drop and will instead keep disciplined and follow through with his or her investing strategy.
3. You've Heard too Many Stock Market Horror Stories
Maybe your dad or your uncle got burned investing in stocks. Maybe a high school teacher told you about her venture into the stock market and how horribly it turned out. Maybe your grandparents' told you stories of the Great Depression and how they only hold cash and bonds. Maybe you've watched one too many news episodes during the Great Recession. Maybe you grew up in a house where there was a lot of misunderstanding and fear about the stock market.
Whatever or whoever go this fear into your head - it's not rational. Stocks have created tremendous amounts of wealth for both rich people and middle-class people over the last century. The Great Depression, the Great Recession, Black Friday, the Dot Com Bust, and all of the other horrible things that happened in the financial markets would not affect an investor that was properly diversified and dollar cost averaging (instead of going all in at once). It's normal that hearing of other people's failures when investing in stocks would make you cautious, but it doesn't have to be that way - you can easily succeed in the stock market if you take a disciplined and prudent approach. More importantly, if you're going to really build wealth and not simply rely on your own income, the stock market is one of your best bets.
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledger technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).