How ’bout them stock markets? Hmmmm…not so good? Well, whatever you do – don’t wimp out and switch your equities to cash, however tempting as it might be. Why is that you ask? To answer that I’m going to go into one of the main lessons of the Four Pillars of Investing – know the history of the markets. This doesn’t mean memorizing any boring dates or who was present at some document signing but rather taking a look at some past market bubbles…and more importantly, some past market crashes. The idea here is to put that famous expression “those who cannot learn from the past are doomed to repeat it” to rest!
Investing in stock markets has a huge behavioural component to it – balance sheets and price/equity ratios are all fine and dandy, but the real question is – can you avoid pulling the trigger on the ‘sell’ button when the markets take a nose dive? Some investors talk of buying when stocks are “cheap” – don’t forget that not selling is the same as buying. If you take a big loss on your investments and sell, then you have locked in your losses and have no chance of profiting from future stock market gains.
William Bernstein, author of The Four Pillars of Investing, has completed a lot of research which show how the stock markets always come back from the depths. His advice is “when things look bleakest, future returns are highest“.
Let’s take a look at two examples from his book:
1929 stock market crash
This is undoubtedly the most famous stock market crash of all time – over the course of almost 3 years, the Dow Jones Industrial Average lost about 90% of its peak value from Sept 3, 1929 to July 8, 1932. Needless to say, this event was quite devastating and many former investors swore off equities forever. Investors who stayed in equities were rewarded however, since the markets returned 15.4% annually for the 20 years following the 1932 bottom.
This market crash followed a period of great market returns due to the phenomenon of the “nifty fifty” companies. Unfortunately the “fifty” weren’t so “nifty” after all and the Dow Jones lost almost half its value (sound familiar?) from the beginning of 1973 to the end of 1974. Bernstein introduces an interesting statistic – in the late 1960′s, which was the middle of a huge bull market, 30% of American households owned stocks. By the late 1970′s and early 1980′s which was after the big crash, only 15% of of households owned any stocks. It is unfortunate that so many investors chose to leave the market when the going got rough, because the market returned 15.1% annually for the 20 years following the 1974 bottom.
Stock market prediction time
I’m no economist or stock picker but one of the interesting things I recently found out about the 1929 crash was that the Dow Jones had increased approximately 350% (not including dividends) in the 5 years prior to crash. 350% in five years is absolutely amazing and it shouldn’t be a huge surprise that a bubble had formed. The aftermath of that bubble was that the equity markets lost 90% of their value (from the peak). Is this happening again? I doubt it, the returns of the US equity markets have been relatively modest in the past few years so it is hard to believe that a major bubble had formed. My grand prediction? The US equity markets will not lose 90% of their peak value, but rather a lesser number – hopefully much less.
Switching your equity investments to cash after they go down is not a good way to invest. After events like the markets we have suffered through this year, there is nothing wrong with revisiting your asset allocation but the best thing you can do is to learn more about investing. Study past market history, read investing books, blogs (especially this one) and keep track of your investments. If you have an advisor then talk to them frequently and make sure you know what you are invested in. Stock markets go up and down – the more you are prepared for it, the easier it will be to ride out both the good times and the bad times.