My father’s friend, Ken, recently sent me an email. He asked: “Is it a good time to add money to U.S. stocks now? I recently came into some cash, and the Dow has dropped a lot over the past few months. Using Warren Buffett’s logic, is it a good time to buy? Some financial people say I shouldn’t be in a hurry because it might drop further.”
If U.S. stocks don’t get off the canvas before the New Year’s bell, it will be their first calendar-year loss since 2008. Between January 1 and December 24th, the Dow Jones Industrials dropped 9.97 percent. The S&P 500 dropped 10.49 percent. These aren’t horrific year-to-date declines. But the rate they fell over the past 3 months has many people worried.
Over the 3-month period ending December 24 , 2018, the Dow Jones Industrials dropped 17.14 percent. The S&P 500 fell 19.08 percent. Plenty of people are starting to panic. Others are looking for answers or guides. So let me offer a stock market tip from an unexpected place: a recipe for chili.
1 lb. ground beef
1 small white onion, diced.
3 (15 oz.) cans diced tomatoes with green chiles.
2 (15 oz.) cans beans, drained (black beans, kidney beans, a combo, or whatever you like)
2 Tbsp. chili powder.
This chili recipe has five ingredients. Each is proportioned for flavor. Now imagine a pesky chili-loving neighbor. He smells your cooking, so he grabs a Bavarian-sized beer mug and comes over, uninvited. You try to protect your chili, but he’s a pretty big guy. He knocks you aside, fills his mug with chili and then bolts for the door.
He took some of your family’s dinner, so you’ll need to make more. A goofy song about tomatoes is playing on the radio. Your son or daughter walks past, juggling three tomatoes. With tomatoes on the brain, you open two more cans of diced tomatoes and add them to your pot. If you stop right there, you would have a horrible pot of chili. After all, it would no longer reflect the original recipe.
The same could be said for Ken’s portfolio…if he added more money to his U.S. stock index. Ken has the right idea. Market drops are good for prospective buyers. But he needs to think about that chili.
About ten years ago, I helped Ken build a diversified portfolio of low-cost index funds. His recipe included 40 percent in a U.S. bond market index, 35 percent in a U.S. stock index and 25 percent in an international stock index.
Media headliners love the recent stock market drop. If it bleeds, it leads. Unfortunately, such headlines are creating what Daniel Kahneman and Amos Tversky called an availability heuristic. A bombardment of downward stock market news can brainwash plenty of people.
For example, news networks love stories about tornadoes. They rarely, if ever, report the deaths caused by asthma. That’s why most Americans believe tornadoes kill more people than asthma. But the comparison isn’t close. Tornadoes kill about 50 Americans a year. Asthma wipes out more than 4000. The availability heuristic creates an illusion.
The decline in U.S. stocks is this month’s tornado. Ken’s whirling thoughts say they’re a great deal now. But thoughts of further drops make him wonder if he should wait.
Fortunately, Ken’s questions can be answered in that recipe for chili. If he adds more ingredients, his pot should reflect the original recipe. That goes the same for his portfolio. Here’s his original goal allocation:
35% U.S. stocks
25% International stocks
Ken Has Cash…What Should He Buy?
|Ken’s Goal Allocation And Actual Allocation, January 2018||Hypothetical Dollar Allocation January 2018||Year-To-Date Return *||Ken’s Allocation - December 24 , 2018||Dollar Value December 24 , 2018|
|*Year-to-date returns to December 24 , 2018, using the following Vanguard funds: VFINX, VGTSX, VBMFX|
Ken shouldn’t let the availability heuristic grab him by the gonads. Note the table above, specifically the parts in blue. Ken’s original goal allocation calls for 35 percent U.S. stocks. Despite the recent U.S. stock market decline, Ken’s U.S. stock market allocation is 34.08 percent. That’s close to his original allocation. As such, if he has money to invest, he shouldn’t add it to his U.S. stock index.
However, Ken’s international stocks have dropped below his goal allocation. And his bonds now represent a higher percentage than what he intended.
That’s why, if Ken had a few thousand dollars to invest, he should buy more of the international stock market index and sell a small portion of his bond market index. Doing so would bring his portfolio closer to its original allocation.
Now assume Ken’s portfolio was worth $91,931 . Assume he inherited $100,000. If he invested that money, he would need to divide it into each of his index funds. But he should do so in proportion to his goal allocation, much as somebody would if they were expanding their pot of chili.
Intelligent investing really is simple. But that doesn’t make it easy. Human emotions push too many off track. And the media doesn’t help.
Instead of listening to your heart or the media, invest money as soon as you have it. Ignore market forecasts. Ignore recent market movements. Turn off the television when pundits talk about stocks. Smart investors know that only three things matter: diversification, low costs, and maintaining your portfolio’s goal allocation. Everything else is a foul-tasting meal that could ruin your financial health.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas