Market crash? Bring it on

Investors ‘are elated when stock prices rise and depressed when they fall’, as Warren Buffett once said, but they should be cheering when stocks go on sale

Fear sells. Headlines such as “Why a stock market crash may once again be inevitable”, “Countdown to the stock market crash of 2016”, and “Europe’s top asset manager says stock market crash possible” have all appeared in recent weeks, and similarly dire warnings have been doing the rounds ever since the global bull market began in 2009.

Paying heed to the perma-bears is generally a bad idea. After all, crash predictions are almost invariably wrong. That aside, what if investors took a different tack; what if they decided to hope for a market crash instead of fearing one?

Unless you're about to retire and cash in your pension fund, a market crash or extended bear market may be just what the doctor ordered. Most people invest via their pension funds, drip feeding money into their investment accounts on a monthly basis over many years. "Even though they are going to be net buyers of stocks for many years to come," as Warren Buffett once pointed out, "they are elated when stock prices rise and depressed when they fall."

Lost decade

Buffett’s point – that investors benefit when stocks go on sale – is a simple but counterintuitive one. For example, most investors found the noughties to be a trying decade. Stocks were outrageously expensive in 2000, and the long bear market that followed resulted in equities halving in value. Indices everywhere advanced between 2003 and 2007, only to suffer an even worse battering during the global financial crisis. By early 2009, valuations were at levels unseen since the early 1980s.

READ MORE

Between 2000 and the end of 2009, the S&P 500 lost a quarter of its value, making it the worst decade since the 1930s. European investors did even worse, and indices in many countries – including Ireland, where the Iseq remains below 2001 levels – have ultimately gone nowhere over the last 15 years.

You won't find many investors cheering on the fact that stocks suffered a lost decade. However, as money manager and A Wealth of Common Sense blogger Ben Carlson noted earlier this year, investors with a multi-decade horizon should want their poor returns upfront. Carlson relates the story he told to a disillusioned friend in early 2009, at the very depths of the financial crisis. "Look at it this way," he said. "You just made 10 years of contributions at more or less the same average share price. You were able to buy in at lower prices consistently for the majority of the first 10 years of your career – a career that will probably last 30-40 more years. Time is on your side. This is actually a good thing once the markets ever recover".

Recover they did – US stocks have tripled over the last six years.

Stagnation

Of course, the recovery in Europe has been nowhere near as stellar, and cautious investors may be fearful of the prospect of secular bear markets that are characterised by decades of underperformance. Over the last 25 years, Japanese stocks have halved in value. US stocks went nowhere between 1929 and 1954, between 1966 and 1982, and again between 2000 and 2013.

That’s not the full story, however. Firstly, the above figures do not include dividends. Include dividends, and US stocks reclaimed their 1929 high in 1945, not 1954. Furthermore, as mentioned earlier, most investors invest by regularly drip-feeding money into investment accounts. This means they buy more stocks when prices are low, and less when prices are high. Consequently, they tend to get back to their break-even point relatively quickly. According to online finance firm CircleBlack, anyone who invested $1,000 in 1929 and who deposited the same sum in every subsequent year, would have been in profit by 1936. The recovery time is much quicker in less severe bear markets.

Meltdown or melt-up?

The most eye-popping statistics, however, come from the acclaimed Philosophical Economics blog, written by pseudonymous blogger

Jesse Livermore

. In a post last year, he posed the question: which is better, a 30-year investment in an index that falls by 66 per cent and never recovers, or one that immediately triples in value? It’s natural to assume the latter is preferable; after the first year, a €1,000 investment will be worth €3,000, compared to just €334 for the poor investor who has had to suffer an epic 66 per cent crash.

However, by focusing on index prices, investors often end up forgetting the crucial role of dividends in boosting real-life returns. Dividend yields rise when share prices fall, and fall when share prices rise. In the 66 per cent crash scenario, the investor’s initial lump sum has been decimated but he is left with a tasty dividend yield. Over time, the reinvestment of his dividends allows him to play catch up. Incredibly, after 30 years, he will be ahead. “The plunge is demonstrably better for your retirement than the melt-up,” the blogger concludes, “with the obvious caveat that you have to maintain discipline and stick with the investment.”

Fears

Why then do investors have such an outsized fear of market declines? Partly, it’s a question of knowledge and maths – it’s likely that even the savviest of financial advisors would not have realised that a permanent 66 per cent plunge need not spell doom for long-term investors.

Additionally, investors aren’t helped by an alarmist media and a hopelessly short-termist analyst culture. When stocks fall, words like ‘carnage’ and ‘collapse’ are bandied about. Investors are told of trillions of dollars being ‘wiped out’ when stocks tumble, even though indices may merely have pulled back to levels seen a couple of months earlier. Analysts are forever suggesting that investors steer clear in times of uncertainty, rather than advocating that investors take a long-term view and aim to simply ride out the inevitable volatility.

More crucially, perhaps, is the fact that all of us are prone to what behavioural economists call loss aversion – the fact the pain of a euro lost is much greater than the joy of a euro gained. Instances like Black Monday in October 1987, when the US stock market plunged by more than 20 per cent in a single day, are burned into investors’ collective memory. In contrast, few people realise the S&P 500 actually ended the year with gains of 5 per cent. By the end of 1989, the index had gained another 50 per cent. The same goes for the 2008-09 market crash, a traumatising experience that left all too many investors too shell-shocked to act on a once-in-a-generation buying opportunity.

Inevitable

The pity is that market history teaches us that unnerving market declines are both inevitable and temporary. Since 1945, US indices have suffered 27 double-digit corrections, and 12 full-blown bear markets (declines of 20 per cent or more). As for the longer variety – those dreaded secular bear markets where stocks stagnate for years on end – regular investors with a multi-decade horizon have little to fear.

Rather than dreading a severe market decline, investors should steel themselves and say: bring it on.