It’s always good to keep in mind what can happen when you’re investing. Since investing is about probability, there is always a chance of the worst case scenario playing out. Most investors are positive about the future. You have to be if you’re willing to put your money out into the world and expect it to come back to you in larger quantities. After all, you wouldn’t put your money to work if you had a negative outlook. Like entrepreneurs, investors need feel good about the future prospects of their business.
Now sure there are doom and gloomers who have a negative view of the market. These “investors” may be taking a short position in the market or they may simply be trying to gain a following to market their proven investing “system.” Yes, there are people that play on your fear just to make a quick buck off you. They may impart their view of the impending collapse of the market and then try to sell you their newsletter. But for now, we’ll consider most investors to be of the long-oriented positive variety.
Now consider that you’re invested 100% in the stock market and a current day Great Depression occurs. Here’s what that would look like on a hypothetical $500,000 portfolio today.
For this chart, I took Dow Jones Industrials data from the start of 1929 through the end of 1932 and replicated what that would look like today. At the beginning of 1929, stocks were doing just fine. In fact, for most of the year, your returns would have been incredible. Your $500,000 portfolio would have increased to $635,283, a gain of 27% in about eight months. Investing in stocks seemed like a sure thing, until the day they didn’t.
I’m reminded of a parable in Nassim Taleb’s 2007 book, The Black Swan, in which he relays a story of a turkey’s life. If you look at life through the perspective of the turkey, your days pass with the same events and you’re happy. The farmer comes out to feed you everyday. You’re growing and playing with other turkeys. The same thing happens to you day after day so you’d have no reason to believe that the next day is any different than the last. Until the fateful day comes when the farmer comes by to turn you into a Thanksgiving dinner.
The market can lull investors into a false sense that you’ll get similar results tomorrow to the results you got yesterday. The stock market may have risen a half percentage point each week for the past year. You think, “Why should I expect anything different? My expected returns are 10% per year and so the market will fulfill my wishes.” It’s pretty normal to get suckered into this way of thinking. It’s called recency bias: a bias where market participants expect similar performance to what the stock market just provided. If the market has done well recently, investors believe that the market will do well in the future. This can lead investors to make bad decisions, like investing on margin because they believe their return will be higher than the interest they’re paying on their margin debt.
That’s not how the market works though. Most people understand that the market can swing wildly, but few investors understand how strong recency bias plays a part in their decision making. When things are going good, people think they’ll continue to go well. After all, they have stock market cheerleaders tell them everyday that the economy is doing great and that the market is expected to close at 10% higher by year end. The stock market doesn’t care about forecasters. The stock market doesn’t care about your expected returns either. The only thing the stock market does is keep track, on a numerical basis, the health of companies and the expectations of market participants. That’s it in a nutshell. If either one of these overarching variables, company performance or investor expectations, takes a dive, then the stock market will also take a dive.
Boom & Bust
We’re in a boom and bust semi-capitalistic system, where the business cycle will ultimately cause wild gyrations in the stock market. Who said the economy and the business cycle should be smooth, upward, and to the right? The economy and subsequent returns of the stock market are simply a gauge of activity. The activity comes in the form of the business cycle. During the expansion part of the cycle, the economy grows in real terms (after accounting for inflation). Things like employment, wages, and industrial activity are all improving during the expansion phase. These are real indicators that are measurable. An expanding economy is the default mode for our economy. Expansions last much longer than contractions, which usually yield steep but swift drops in the stock market.
When everyone believes that the stock market will continue to go higher and higher, and in particular when there are speculative bubbles, is exactly when you should be cautious in the market. In short: don’t be a turkey. That’s not to say that you should exit the market if you feel that it is overvalued. An overvalued market will usually continue to be overvalued. The one thing you can do when the business cycle is toward the end of an expansionary cycle is to lower your expectations about future results. And this can be hard to do because of recency bias. You may expect the stock market to return 10% for the next five years because it’s returned, on average, 10% for the previous five years. This is almost never the case though.
Stocks are like toddlers: they’re both guaranteed to act exactly the opposite way in which you’d like them to. Both to no fault of their own. A toddler doesn’t yet know their own behavioral expectations their parents have placed on them much like the stock market doesn’t know your expected rate of return. If you think the stock market will return 10% annually over the next five years, you’re more likely to get this sequence of returns:
Year 1 – 12% gain
Year 2 – (27%) loss
Year 3 – 15% gain
Year 4 – 12% gain
Year 5 – 5% gain
In the above sequence of returns, your compounded annual return is only 3.2%. In this example, some of the years’ returns are pretty good relative to the risk-free rate. However, that year 2 loss is significant and has a huge impact your overall five-year return. This is what happens to investors when they put their money to work toward the end of a cycle of business expansion. It’s better to properly diversified across investment categories.
Investors need to temper their expectations. A late-stage bull market may lead people to expect larger returns, but that’s just the opposite of what a late-stage bull market provides. It leads everyone to believe that the stock market is risk-free and highly rewarding. Investing is about probability. Anything can happen but what are your chances?