It wasn’t normal. In 2006, Floyd Landis stood on his pedals and left the world’s best Tour de France cyclists gasping in his wake. I still remember watching it on television. It was as if the Pennsylvanian were shot from a cannon. In the modern era, most of the race’s stage victors win by seconds. But that day, Floyd Landis gained more than six minutes. Not even Lance Armstrong, in his drug-fueled heyday, crushed his competitors by six minutes in a single day.
Floyd Landis soon stood on the podium as the overall winner. But a few days later, his titled was stripped because Landis tested positive for drugs. According to Tyler Hamilton, co-author of The Secret Race, if a cyclist thought another rider was on intravenous rocket fuel, the riders never told the press. But they shared their thoughts with one another in cryptic code. They might say, “His performance was extra-terrestrial.” Or they might say, “He was out of this world” or “That wasn’t normal.”
When it’s too good to be true…
Such is the case with the U.S. stock market. If somebody invested $10,000 in the S&P 500 on January 2010, it would have been worth $28,552 by February 28, 2018. Over eight years, it would have grown 185 percent. That’s not normal.
What’s more, investors wouldn’t have seen a single calendar year loss. They would have made money eight years in a row: 2010, 2011, 2012, 2013, 2014, 2015, 2016 and 2017. That isn’t normal either. Over the past 90 years, the S&P 500 has never exceeded an eight-year streak (the recent record ties the period from 1982-1989).
Most professional cyclists from Landis and Armstrong’s era saw normality restored. Their worlds crashed when their doping secrets were revealed. Juiced by optimism, low interest rates and the highs of its own success, U.S. stocks will crash too. The biggest question isn’t when, because nobody knows for sure. The far bigger question is, “Will you be ready when it happens?
After all, almost nine years have passed since investors were tested by a stock market crash. Hundreds of thousands of young, new investors haven’t been tested yet. That’s why, if they don’t hold a bond market index fund, they should probably add one now.
Detractors, however, say bonds are for suckers because interest rates are low. Vanguard’s Total Bond Market Index (VBMFX) has only averaged a compound annual return of 1.58 percent over the past five years. Vanguard’s Short-Term Bond Index (VBISX) has only gained a compound annual return of 0.76 percent over the same time period. Plenty of critics are also quoting Warren Buffett. In his 2017 letter to Berkshire Hathaway shareholders he wrote:
It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.
Lawrence Cunningham’s book, The Essays of Warren Buffett, shows what Buffett means by risk. He doesn’t equate risk with volatility. Warren Buffett, after all, has an iron-clad stomach. Instead, he equates risk with the potential for long-term loss or an opportunity cost.
Over an investment lifetime, having a broad or a short-term bond market index won’t increase the odds of long-term risk. But it might magnify the opportunity cost. In other words, stocks beat bonds over long time periods; therefore, including bonds in a portfolio decreases long-term returns.
When stocks slide, however, investors can lose faith. That’s the biggest danger. They might fear investing regular sums from their paychecks every month. For example, a $10,000 investment in the S&P 500 on January 2000 would have been worth $5,974 on February 28, 2003. That’s more than three years without a profit. It would have been worth just $5,833 on February 28, 2009. That’s more than nine years without a profit. By September 30, 2011, it would have been worth just $9,451. That’s almost 11 years without a profit.
Most investors don’t think like Warren Buffett. We fear short-term losses over long-term gains. Psychologists Daniel Kahneman and Amos Tversky discovered this years ago. During experiments Kahneman would say, ''I'm going to toss a coin, and if it's tails, you lose $10. How much would you have to gain in winnings for this gamble to be acceptable to you?''
If investors enjoyed gains as much as they disliked losses, they might accept $11 for a win if a loss would cost them $10. However, Kahneman and Tversky learned that investors required an average of $20 for the win, before accepting the bet. In other words, they disliked losses two times more than they enjoyed gains.
By including a broad or a short-term bond market index in a diversified portfolio of stock market index funds, investors might mitigate the pain of stock market loss. This might juice their long-term wealth. When investors fear losses, they might stop investing money when the stock market falls–and the financial media calls for the next Armaggedon.
But with a bond index in the mix, their portfolios won’t fall as far. That might boost investors’ courage. It might convince investors to maintain their long-term plan–and keep adding money every month.
After all, stock market crashes are normal. So…is your portfolio and your mindset prepared for the next one?
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas